c



 
  
     

c

Essentially, capital is wealth, usually in the form of money or property. Capital markets exist when two groups
interact with each other viz.; those who are seeking capital and those who provide capital. The capital seekers are
the businesses and governments who want to finance their projects and enterprises by borrowing or selling equity
stakes. The capital providers are the people and institutions who are willing to lend or buy, expecting to realize a
profit.

The central purpose of a corporation is to provide value for the shareholders Or in simple terms, it is to make
money. The discipline that studies money, markets and their operation with an eye to practical application is called
finance. Thus, financial theory has a significant impact on the decisions made by the leaders of corporations.

Accountants have been described as historians. They record how much is spent, earned and invested. They sort,
classify and organize. However, what these actions mean, is not their primary concern. Economists, on the other
hand, are concerned with the more general questions of how markets operate, why they operate thus and what
this means for individuals, businesses and nations. Financial professionals stand in the middle ground. While they
must stay in touch with the accounting and have a keen understanding of the real-world operations of the firm,
they also attempt to understand the esoteric aspects of economic theory.

Though finance requires certain decisions to be made, as opposed to the decisions' impact being recorded,
predictions and estimations must be made. However, unlike economics, which addresses such general questions,
finance professionals use theories, models and statistical tools to answer specific questions. An economist may ask
the question, "Is this industry expanding its operations, and if so, at what rate?" The financial professional may use
some of the same tools, but is more likely to ask, "Should our company expand operations, and if so, when?"

In case of distinction made between finance and economics , then there is a possibility of some overlap between
the disciplines and indeed, some of the most esteemed scholars in financial theory are great economists. John
Maynard Keynes, William Sharpe and Oskar Morgenstern were responsible for innovations like the capital asset
pricing model and modern portfolio theory. However, these scholars are almost universally referred to as
economists, not financial theorists.

While financial theory, like all theory, is imperfect, it does provide rational guidance for dealing with uncertainty.
For example, analysts may regard the company's stock price as too low. This may lead the directors of the
corporation to purchase shares of the stock from shareholders, allowing the firm to retain more of its profits as it
would not have to pay dividends on shares that it repurchased. Another possibility would be theorists predicting
significant changes in the interest rates demanded by credit markets. The corporation may then hasten, or delay,
obtaining needed credit lines.

The greatest challenge to financial theory is the reliance on reason. While objective assessment of measurable
facts and application of proven formulas may seem unassailable, as Publius Syrus said "Everything is worth what its
purchaser will pay for it." Pricing models, market statistics and economic data may be invaluable for providing
predictions, but sometimes a particular product, company or brand name may fall into fashion or out of favor for
reasons that may be apparent only in retrospect or forever remain inscrutable.

Let us first see what exactly are the financial markets and institutions.
A financial market is a market in which financial assets are traded. In addition to enabling exchange of
previously issued financial assets, financial markets facilitate borrowing and lending by facilitating the
sale by newly issued financial assets. Examples of financial markets include the Dar es Salam Stock
Exchange (DSE), (resale of previously issued stock shares), the Tanzanian government bond market
(resale of previously issued bonds), and the Treasury bills auction (sales of newly issued T-bills). A
financial institution is an institution whose primary source of profits is through financial asset
transactions. Examples of such financial institutions include discount brokers (e.g., Charles Schwab and
Associates), banks, insurance companies, and complex multi-function financial institutions such as
Merrill Lynch.

Financial markets serve six basic functions. These functions are briefly listed below:

! r


: Financial markets permit the transfer of funds (purchasing power) from
one agent to another for either investment or consumption purposes.
! 




  : Financial markets provide vehicles by which prices are set both for newly
issued financial assets and for the existing stock of financial assets.
! O
  

  
  : Financial markets act as collectors and aggregators
of information about financial asset values and the flow of funds from lenders to borrowers.
! á
: Financial markets allow a transfer of risk from those who undertake investments to
those who provide funds for those investments.
!  : Financial markets provide the holders of financial assets with a chance to resell or
liquidate these assets.
!

: Financial markets reduce transaction costs and information costs.

In attempting to characterize the way financial markets operate, one must consider both the various
types of financial institutions that participate in such markets and the various ways in which these
markets are structured.

 
 


 

These are the types of financial markets which are as under,

! 

Capital market is a market where companies and government raise their capital
for its operations and investment.
! ã
Stock market is a public place where stocks and securities are traded.
! r 
rond market is a financial place where debt securities and bonds are traded.
! 
 
 Commodity markets are those markets where raw material and primary
products are traded.
!   
 Money markets are those markets where assets and other one year maturity
securities are traded is called money market.
! 



Derivative markets are those markets which deals the future contracts.
! h

Future market deals the buying and selling of commodities on a specified future
date.
!  
 
Insurance market deals the risk of loss in future or uncertain period.
! h

   
Foreign exchange market is the world wide market which deals the
different currencies.
m
  

 
m  
ry definition, financial institutions are institutions that participate in financial markets, i.e., in the
creation and/or exchange of financial assets. At present in the United States, financial institutions can be
roughly classified into the following four categories: "brokers;" "dealers;" "investment bankers;" and
"financial intermediaries."

r

A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller
(or buyer) to complete the desired transaction. A broker does not take a position in the assets he or she
trades -- that is, the broker does not maintain inventories in these assets. The profits of brokers are
determined by the commissions they charge to the users of their services (either the buyers, the sellers,
or both). Examples of brokers include real estate brokers and stock brokers.

i


 

  


 Payment Payment
ã!r!"
 Stock ruyer Stock Seller

 (Passed Through)
Stock Shares Stock Shares


i
 

Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not engage in
asset transformation. Unlike brokers, however, a dealer can and does "take positions" (i.e., maintain
inventories) in the assets he or she trades that permit the dealer to sell out of inventory rather than
always having to locate sellers to match every offer to buy. Also, unlike brokers, dealers do not receive
sales commissions. Rather, dealers make profits by buying assets at relatively low prices and reselling
them at relatively high prices (buy low - sell high). The price at which a dealer offers to sell an asset (the
"asked price") minus the price at which a dealer offers to buy an asset (the "bid price") is called the bid-
ask spread and represents the dealer's profit margin on the asset exchange. Real-world examples of
dealers include car dealers, dealers in U.S. government bonds, and Nasdaq stock dealers.

i


 

  
 i



Payment Payment
 r
rond ruyer rond Seller

ronds (rond Inventory ronds
O
 


¢ 
  





  









 

  
 




! ¢
: Advising corporations on whether they should issue bonds or stock, and, for bond
issues, on the particular types of payment schedules these securities should offer;
! c 
: Guaranteeing corporations a price on the securities they offer, either individually
or by having several different investment banks form a syndicate to underwrite the issue jointly;
! ã
 ¢ : Assisting in the sale of these securities to the public.

Standard rank in Tanzania is the best example of Investment ranking firm.

h

O  

 

Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions that
engage in financial asset transformation. That is, financial intermediaries purchase one kind of financial
asset from borrowers -- generally some kind of long-term loan contract whose terms are adapted to the
specific circumstances of the borrower (e.g., a mortgage) -- and sell a different kind of financial asset to
savers, generally some kind of relatively liquid claim against the financial intermediary (e.g., a deposit
account). In addition, unlike brokers and dealers, financial intermediaries typically hold financial assets
as part of an investment portfolio rather than as an inventory for resale. In addition to making profits on
their investment portfolios, financial intermediaries make profits by charging relatively high interest
rates to borrowers and paying relatively low interest rates to savers.

Types of financial intermediaries include: Depository Institutions (commercial banks, savings and loan
associations, mutual savings banks, credit unions); Contractual Savings Institutions (life insurance
companies, fire and casualty insurance companies, pension funds, government retirement funds); and
Investment Intermediaries (finance companies, stock and bond mutual funds, money market mutual
funds).

i


 
 


 





Lending by r rorrowing by r

Deposited
 Funds
funds
h r #

Loan Deposit
 contracts accounts

 Loan contracts Deposit accounts

issued by F to r are issued by r to H are
liabilities of F and liabilities of r and
assets of r assets of H


NOTE: hMFirms, rMCommercial rank, and #MHouseholds




  
  These four types of financial institutions are simplified idealized
classifications, and many actual financial institutions in the fast-changing financial landscape
today engage in activities that overlap two or more of these classifications, or even to some
extent fall outside these classifications. A prime example is Merrill Lynch, which simultaneously
acts as a broker, a dealer (taking positions in certain stocks and bonds it sells), a financial
intermediary (e.g., through its provision of mutual funds and CMA checkable deposit accounts),
and an investment banker.

 h
 
 

ã

 

The costs of collecting and aggregating information determine, to a large extent, the types of
financial market structures that emerge. These structures take four basic forms:

! Auction markets conducted through brokers;

! Over-the-counter (OTC) markets conducted through dealers;
! Organized Exchanges, such as the Dar es Salam Stock Exchange, which combine auction
and OTC market features. Specifically, organized exchanges permit buyers and sellers to
trade with each other in a centralized location, like an auction. However, securities are
traded on the floor of the exchange with the help of specialist traders who combine
broker and dealer functions. The specialists broker trades but also stand ready to buy
and sell stocks from personal inventories if buy and sell orders do not match up.
! Intermediation financial markets conducted through financial intermediaries;

Financial markets taking the first three forms are generally referred to as securities markets.
Some financial markets combine features from more than one of these categories, so the
categories constitute only rough guidelines.
  


An auction market is some form of centralized facility (or clearing house) by which buyers and
sellers, through their commissioned agents (brokers), execute trades in an open and competitive
bidding process. The "centralized facility" is not necessarily a place where buyers and sellers
physically meet. Rather, it is any institution that provides buyers and sellers with a centralized
access to the bidding process. All of the needed information about offers to buy (bid prices) and
offers to sell (asked prices) is centralized in one location which is readily accessible to all would-
be buyers and sellers, e.g., through a computer network. No private exchanges between
individual buyers and sellers are made outside of the centralized facility.
An auction market is typically a public market in the sense that it open to all agents who wish to
participate. Auction markets can either be call markets -- such as art auctions -- for which bid
and asked prices are all posted at one time, or continuous markets -- such as stock exchanges
and real estate markets -- for which bid and asked prices can be posted at any time the market
 is open and exchanges take place on a continual basis. Experimental economists have devoted a
tremendous amount of attention in recent years to auction markets.
Many auction markets trade in relatively homogeneous assets (e.g., Treasury bills, notes, and
bonds) to cut down on information costs. Alternatively, some auction markets (e.g., in second-
hand jewelry, furniture, paintings etc.) allow would-be buyers to inspect the goods to be sold
prior to the opening of the actual bidding process. This inspection can take the form of a
warehouse tour, a catalog issued with pictures and descriptions of items to be sold, or (in
televised auctions) a time during which assets are simply displayed one by one to viewers prior
to bidding.
Auction markets depend on participation for any one type of asset not being too "thin." The
costs of collecting information about any one type of asset are sunk costs independent of the
volume of trading in that asset. Consequently, auction markets depend on volume to spread
these costs over a wide number of participants.
R

 
 




An over-the-counter market has no centralized mechanism or facility for trading. Instead, the
market is a public market consisting of a number of dealers spread across a region, a country, or
indeed the world, who make the market in some type of asset. That is, the dealers themselves
post bid and asked prices for this asset and then stand ready to buy or sell units of this asset
with anyone who chooses to trade at these posted prices. The dealers provide customers more
flexibility in trading than brokers, because dealers can offset imbalances in the demand and
supply of assets by trading out of their own accounts.
O


  


An intermediation financial market is a financial market in which financial intermediaries help
transfer funds from savers to borrowers by issuing certain types of financial assets to savers and
receiving other types of financial assets from borrowers. The financial assets issued to savers are
claims against the financial intermediaries, hence liabilities of the financial intermediaries,
whereas the financial assets received from borrowers are claims against the borrowers, hence
assets of the financial intermediaries.

 
 

Markets exist to facilitate the purchase and sale of goods and services. The financial market exists to facilitate sale
and purchase of financial instruments and companies of two major markets, namely the capital market and the
money market. The distinction between capital market and money market is that capital market mainly deals in
medium and long-term investments (maturity more than a year) while the money market deals in short term
investments (maturity upto a year). Capital markets provide avenue where companies can raise funds to
expand on their businesses or establish new ones by issuing securities owned by the companies. Like
businesses in the private sector, Government issue its securities to raise funds in capital markets to build
electricity damn, construct new roads, bridges by issues.

Capital market can be divided into two segments viz. primary and secondary. The primary market is mainly used by
issuers for raising fresh capital from the investors by making initial public offers or rights issues or offers for sale of
equity or debt. The secondary market provides liquidity to these instruments, through trading and settlement on
the stock exchanges.
Capital market is, thus, important for raising funds for capital formation and investments and forms a very vital link
for economic development of any country. The capital market provides a means for issuers to raise capital from
investors (who have surplus money available from saving for investment). Thus, savings normally flow from
household sector to business or Government sector, which normally invest more than they save. A vibrant and
efficient capital market is the most important parameter for evaluating health of any economy.

In a market economy, the role of the capital market is very important. The good functioning of the
capital market is vital in the contemporary economy, in order to achieve an efficient transfer of
monetary resources from those who save money toward those who need capital and who succeed to
offer it a superior utilisation; the capital market can influence significantly the quality of investment
decisions. The gathering of temporary capitals that are available in the economy, the reallocation of
those that are insufficiently or inefficiently used at a certain moment and even the favouring of some
sectorial reorganisations, outline the capital market͛s place in the economy of many countries.
Among the mechanisms which are specific for the capital market, the mechanism of financing the
economy is the most important one, although, due to the fact that an ensemble of interconnected
mechanisms contribute to the good functioning of the capital market, the way in which each of them
function determines the quality of the ensemble. Thus, for instance, the efficient allocation of resources,
which is achieved by the help of the capital market, relies on the information obtained on the basis of
the (secondary) market prices. The inadequate functioning of the stock market mechanism ʹ as a
component part of the ensemble mechanism that is specific for the capital market ʹ and eventually the
lack of relevance of the stock market prices, can generate errors inside the system and can alter its
finality. In this case, the efficient allocation of resources will fail to appear, and this is a pithy specific
trace of the capital market.
The contact between agents with deficit of money and the ones with monetary surplus can take place in
a direct way (direct financing), but also by the means of any financial intermediation form (indirect
financing), situation in which specific operators realise the connection between the real economy and
the financial market. In this case, the financial intermediaries could be banks, investment funds, pension
funds, insurance companies or other non-bank financial institutions. Even if, traditionally, the companies
appeared only as agents with deficit of money, in the last two or three decades it could be noticed a
change in the financial behaviour of the modern firms: these are not considering anymore the financial
market (both the capital and the monetary market) only as sources for rising funds (as issuers of
financial assets), but appears more often as buyers of financial assets.
The capital market fulfils the transfer function of current purchasing power, in monetary form, from
companies which have a surplus of funds to those which have a deficit, in exchange for reimbursing a
greater purchasing power in the future; in this way the capital market makes possible to separate the
saving act from the investment one.
In addition, the capital market mechanism allows not only an efficient allocation of the financial
resources available at a certain moment in an economy ʹ from the market͛s point of view ʹ but also
permits to allot funds according the return and the risk ʹ from the investor͛s point of view ʹ offering a
large variety of financial instruments with different profitableness-risk characteristics, suitable for saving
or risk covering. Nowadays, the protection against financial risks becomes a necessity, imposed by the
transformations in the global economy, by the accented instability and the financial crisis that affects
without discrimination both developed and emerging stock markets.
Covering the risk, that could be realised by the help of different operations, market orders or
derivatives, defines the function of insurance against risks, specific function of the capital markets. The
capital market allows risk dispersion between investors (of the diversifiable risk), exactly in the same
measure in which each of them is willing to assume it, too.
From the issuers͛ point of view, the money which is necessary for the development or the unfolding of
their activity can be mobilised by the help of the capital market at accessible costs, theoretically
speaking smaller than those possibly obtained by the help of the banking market or by other financial
intermediaries.
From the investors͛ point of view, the advantages of the mobilisation process (the advantages of the
financial assets), in fact those of the organisation in the form of a joint-stock companies, is under the
propriety transfer, which can be rapidly achieved, in a simple and safe way, by the help of the stock
exchange, due to the securities͛ negotiability. In this context, the stock market facilitates the
investments in financial assets, their circulation and mobility and through the offered suppleness
sustains, indirectly, the economy͛s financing by the help of primary market. The good primary market
functioning depends also on the credibility, attractiveness and efficiency of the secondary market.
Through the secondary market, a negotiation one, the financial assets owners have the possibility of
converting it in cash money. Few persons would invest in securities without the certitude that could
transform them in money, at the market price, selling on the stock market. The stock exchange inspires
trust to participants, confers legality to operations and trust to obtain the best price at the moment. The
stock exchange credibility is sustained also by regulations and assumed deontology rules, in the last
years insisting on the ethic dimension of the capital market.
The capital market allows the property separation from joint-stock company management, shareholders
having the option for this the delegation of a professional team, which can be permanent monitored,
and whose mandate will finally be the maximisation of the market value of the company͛s shares. ry the
means of concentrating a large number of stocks, some of the significant shareholders will have the
possibility to implicate ʹ directly or through their representatives ʹ in the management of the company
that (partially) they owned, this way contributing to the general development of the economy. In fact,
the stock market, through the transparency insured and the control possibilities stimulate the
management of the listed companies to a better administration.
It is well funded the observation that in developing countries we should pay the same attention to the
set up and development of an efficient capital market, in the same way in which there are
preoccupations for the infrastructure or telecommunications͛ development.
This thing becomes more important in the transitional countries, taking into account the necessity of
resources reorientation from the inefficient sectors towards the efficient ones, being thus ensured the
increasing efficiency in economy, being supported both the economic reform process and the
privatisation process. The stock exchange is labelled as a ͞resonance box͟ for the economical, political
and social events, both internal and international, reflecting as a real barometer the state of the
economy. It is justified that the stock market cannot be ʹ at least not on the long run) ͞better͟ than the
real economy, being in fact their reflect.
If the real economy absolutely influences the evolution of the stock market, the reverse is also of
interest: the flows on the secondary market are useful clues and determinates reorientation of funds to
the primary market, reconsideration of options regarding the investments, in a whole, an more efficient
allot of the funds available at a certain moment. The impact of the stock market on the real economy is
important, because investors from the developed countries are used to watch the market͛s evolution
and to take into account the information thus offered regarding the economy͛s future. The symbolic
values, the securities, need a real basis for conferring economic viability; without this, the ͞virtuous
circle͟ could transform into a ͞vicious circle͟, the capital market is disconnected to the real economy.
The importance of the capital market in an economy is given by the significant role played in the firms͛
and state͛s financing, by the weight of the direct financing among the financing modalities. reside the
apparent important thing ʹ the large transaction volume on the stock market ʹ what it really matters is
the place which is taken by the (primary) capital market in the development of the joint-stock
companies (direct financing), and this thing is sometimes forgotten, or appears as secondary.
In the same idea comes another observation, concerning the danger of exaggerate orienting the
attention toward the secondary market, not to the primary one: ͞[͙] the markets and the financial
activity are only modalities for reaching a final objective. The bankers, the brokers and the other
professionals in the field aren͛t anything else that pipes through which circulate money from the saver
to the final user. Often, the pipes tend to assume a greater importance than the two ends of the circuit,
utilising various artifices [͙]͟.
The well functioning of the capital market is a solid foundation for the insurance of a lasting growth, on
a long term, of the national economy; the financial market and first of all the capital market represents
in many countries ʹ and it also could represent in Romania, too ʹ the engine for the economic
development.
For the transitional countries towards the economy market, the stock exchange mechanism was only
one of the mechanisms that had to be rediscovered.
Although the capital market has suffered profound transformations in the developed countries during
the last decades, the modernisation was rather institutional and organisational and less from the
specific mechanisms͛ point of view. From some points of view, the transitional countries have made
many progresses lately with a view to the capital market, especially the secondary one, approaching the
level of the countries with tradition in the domain. Unfortunately, the modern infrastructures,
computers, the performant telecommunication system, the adequate software, are not enough. In order
to have a functioning stock market mechanism, fulfilling its primordial function, we need savings, trust in
the economy͛s perspectives, and an increasing production.

The capital market in Tanzania can be described as an ͞emerging market͟. rank financing and
government subsidies have for along time been a source of finance for state corporations and
companies. There is a noticeable absence of publicly owned companies (i.e., companies allowed to
invite subscriptions from the public). Many companies are private, i.e., companies whose right to
transfer shares is severely limited. The number of securities is limited, with government debt
instruments being the only securities in the market (stocks treasury bills and bonds). Pension and
provident funds are the only major collective investment schemes and there are no unit trusts.

In the transition of the country͛s economy from a ͞planned͟ economy, dominated by parastatal
enterprises, towards a ͞market͟ economy, where the private sector is expected to play an increasingly
important role, the Capital Markets and Securities Act was enacted. As a result the first stock exchange
has just started operations in Tanzania.

h 


 

Tanzania introduced the Interbank Foreign Exchange Market (IFEM) in 1994, initially conducted on an
open outcry basis, with authorized dealers assembled at the rank of Tanzania. The rank of Tanzania
supervised the daily sessions by inviting offers and bids and awarding deals at the highest bid.
Telephone dealing was later introduced in May 1996. Authorised dealers are now considering
introducing electronic dealing.

The mode of payment is agreed as stated in the contract and indicated in the deal confirmation slip.
Either a rank of Tanzania transfer, cheque or bankers payment (which are cleared and settled like any
other cheque in the clearing houses) effects payment.
In the case where transfer is through current accounts maintained at the central bank, entries are
passed on due date by debiting or crediting the respective bank͛s local currency accounts. Where
payment also involves US dollars, the dollar accounts are debited or credited accordingly. rureaux de
change and banks cater for the retail market in which individuals and business satisfy their foreign
exchange requirements.

h 
  




The major objectives of capital market are:

! To mobilize resources for investments.

! To facilitate buying and selling of securities.
! To facilitate the process of efficient price discovery.
! To facilitate settlement of transactions in accordance with the predetermined time schedules.

    
  

Investment is a deployment of funds in one or more types of assets that will be held over a period of time. Various
forms of investment are available to an investor. They cover bank deposits, term deposits, recurring deposits,
company deposits, postal savings schemes, deposits with non-bank financial intermediaries, Government and
corporate bonds, life insurance and provident funds, equity shares, mutual funds, tangible assets like gold, silver
and jewellery, real estate and work of arts, etc.

Capital market instruments can be broadly divided into two categories namely

! Debt, Equity and Hybrid instruments.

! Derivative Products like Futures, Options, Forward rate agreements and Swaps.

$: Instruments that are issued by the issuers for borrowing money from the investors with a defined tenure
and mutually agreed terms and conditions for payment of interest and repayment of principal.

Debt instruments are basically obligations undertaken by the issuer of the instruments as regards certain future
cash flows representing interest and principal, which the issuer would pay to the legal owner of the instrument.
Debt instruments are of various types. The key terms that distinguish one debt instrument from another are as
follows:

! Issuer of the instrument

! Face value of the instrument
! Interest rate and payment terms
! Repayment terms (and therefore maturity period/tenor)
! Security or collateral provided by the issuer.

Different kinds of money market instruments, which represent debt, are commercial papers (CP), certificates of
deposit (CD), treasury bills (T-bills) etc.

"%
: Instruments that grant the investor a specified share of ownership of assets of a company and right to
proportionate part of any dividend declared. Shares issued by a company represent the equity. The shares could
generally be either ordinary shares or preference shares.
 &


  $' "%
 $: Share represents the smallest unit of ownership of a company. If a
company has issued, 1,00,000 shares, and a person owns 10 of them, he owns 0.01% of the company. A debenture
or a bond represents the smallest unit of lending. The bond or debenture holder gets an assured interest only for
the period of holding and repayment of principal at the expiry thereof, while the shareholder is part-owner of the
issuer company and has invested in its future, with a corresponding share in its profit or loss. The loss is, however,
limited to the value of the shares owned by him.

#$

 : Instruments that include features of both debt and equity, such as bonds with equity warrants e.g.,
convertible debentures and bonds.




 : Derivative is defined as a contract or instrument, whose value is derived from the underlying asset, as
it has no independent value. Underlying asset can be securities, commodities, bullion, currency, etc. The capital
market in Tanzania is not sufficiently mature or deep enough to support derivatives on equities.
Therefore, CMSA does not see, within the period covered by this Strategic Plan, any consideration being
given to, for example, equity options, single stock futures, or exchange traded funds. It does see
however the possibility of other derivatives such as:
ͻ Index futures or index options;
ͻ Interest rate futures;
ͻ Currency futures or options;
ͻ Commodity futures.
During the life of the Strategic Plan, the CMSA will conduct a study of the feasibility of introducing one
or more of the above derivative products. In the meantime however, the Act will be amended to ensure
that it caters for all forms of derivative instruments.
h
 (  ã)Futures are the standardized contracts in terms of quantity, delivery time and place for
settlement on a pre-determined date in future. It is a legally binding agreement between a seller and a buyer,
which requires the seller to deliver to the buyer, a specified quantity of security at a specified time in the future, at
a specified price. Such contracts are traded on the exchanges.


  (    ã) These are deferred delivery contracts that give the buyer the right, but not the
obligation to buy or sell a specified security at a specified price on or before a specified future date.

ã  
 


The Capital Market consists of primary markets and secondary markets.

*


 
: A market where the issuers access the prospective investors directly for funds required by them
either for expansion or for meeting the working capital needs. This process is called disintermediation where the
funds flow directly from investors to issuers.

Securities
Company/Issuer Investors

The other alternative for issuers is to access the financial institutions and banks for funds. This process is called
intermediation where the money flows from investors to banks/ financial institutions and then to issuers.
Primary market comprises of a market for new issues of shares and debentures, where investors apply directly to
the issuer for allotment of shares/debentures and pay application money to the issuer. Primary market is one
where issuers contact directly to the public at large in search of capital and is distinguished from the secondary
market, where investors buy/sell listed shares/debentures on the stock exchange from/to new/existing investors.

Primary market helps public limited companies as well as Government organizations to issue their securities to the
new/existing shareholders by making a public issue/rights issue. Issuer͛s increase capital by expanding their capital
base. This enables them to finance their growth plans or meet their working capital requirements, etc. After the
public issue, the securities of the issuer are listed on a stock exchange(s) provided it complies with requirements
prescribed by the stock exchange(s) in this regard. The securities, thereafter, become marketable. The issuers
generally get their securities listed on one or more than one stock exchange. Listing of securities on more than one
stock exchange, enhances liquidity of the securities and results in increased volume of trading.

A formal public offer consists of an invitation to the public for subscription to the equity shares, preference shares
or debentures has to be made by a company highlighting the details such as future prospects, financial viability and
analyze the risk factors so that an investor can take an informed decision to make an investment. For this purpose,
the company issues a prospectus in case of public issue and a letter of offer in case of rights issue, which is
essentially made to its existing shareholders. This document is generally known as Offer document. It has the
information about business of the company, promoters and business collaboration, management, the board of
directors, cost of the project and the means of finance, status of the project, business prospects and profitability,
the size of the issue, listing, tax benefits if any, and the names of underwriters and managers to the issue, etc.

The issuers are, thus, required to make adequate disclosures in the offer documents to enable the investors to
decide about the investment.

Making public issue of securities is fraught with risk. There is always a possibility that the issue may not attract
minimum subscription stipulated in the prospectus. The risk may be high or low depending upon promoters
making the issue, the track record of the company, the size of the issue, the nature of project for which the issue is
being made, the general economic conditions, etc. Issuers would like to free themselves of this worry and attend
to their operations wholeheartedly if they could have someone else to worry on their behalf. For this purpose the
companies approach underwriters who provide this service.

Normally, whenever an existing company comes out with a further issue of securities, the existing holders have the
first right to subscribe to the issue in proportion to their existing holdings. Such an issue to the existing holders is
called ͚Rights issue͛. The price of the security before the entitlement of rights issue is known as the cum-rights
price. The price after the entitlement of rights issue is known as the ex-rights price. The difference between the
two is a measure of the market value of a right entitlement. An existing holder, besides subscribing to such an
issue, can let his rights lapse, or renounce his rights in favor of another person (free, or for a consideration) by
signing the renunciation form.

The companies declare dividends, interim as well as final, generally from the profits after the tax. The dividend is
declared on the face value or par value of a share, and not on its market price. A company may choose to capitalize
part of its reserves by issuing bonus shares to existing shareholders in proportion to their holdings, to convert the
reserves into equity. The management of the company may do this by transferring some amount from the reserves
account to the share capital account by a mere book entry. ronus shares are issued free of cost and the number of
shareholders remains the same. Their proportionate holdings do not change. After an issue of bonus shares, the
price of a company͛s share drops generally in proportion to the issue.
¢


 
 *


 

1. Appointment of merchant bankers
2. Pricing of securities being issued
3. Communication/ Marketing of the issue
4. Information on credit risk
5. Making public issues
6. Collection of money
7. Minimum subscription
8. Listing on the stock exchange(s)
9. Allotment of securities in demat / physical mode
10. Record keeping

ã 
 
: In the secondary market the investors buy / sell securities through stock exchanges. Trading of
securities on stock exchange results in exchange of money and securities between the investors.

Secondary market provides liquidity to the securities on the exchange(s) and this activity commences subsequent
to the original issue. For example, having subscribed to the securities of a company, if one wishes to sell the same,
it can be done through the secondary market. Similarly one can also buy the securities of a company from the
secondary market.

A stock exchange is the only important institution in the secondary market for providing a platform to the investors
for buying and selling of securities through its members. In other words, the stock exchange is the place where
already issued securities of companies are bought and sold by investors. Thus, secondary market activity is
different from the primary market in which the issuers issue securities directly to the investors.

Traditionally, a stock exchange has been an association of its members or stock brokers, formed for the purpose of
facilitating the buying and selling of securities by the public and institutions at large and regulating its day to day
operations.

¢



+
 

1. Dar Es Salaam Stock Exchange (DSE)

2. East African Member States Securities and Regulatory Authorities (EASRA)
3. Capital Markets Development Committee (CMDC)
4. The International Organization of Securities Commissions (IOSCO)



" ãã"  (ã")
The Dar es Salaam Stock Exchange was incorporated in September 1996 as a private company limited by guarantee
and not having a share capital under the Companies Ordinance (Cap. 212). The DSE is therefore a non-profit
organization created to facilitate the Government implementation of the economic reforms and in future to
encourage the wider share ownership of privatized and all the companies in Tanzania and facilitate rising of
medium and long-term capital.
The formation of the DSE followed the enactment of the Capital Markets and Securities Act, 1994 and the
establishment of the Capital Markets and Securities Authority (CMSA), the industry regulatory body charged with
the mandate of promoting conditions for the development of capital markets in Tanzania and regulating the
industry.

" ¢

  $
ã ã


  
¢ 


 ("¢ã¢)
EASRA is made upcomprised of the Capital Markets Authority Kenya (CMA (K)), Capital Markets Authority Uganda
(CMA (U)) and the Capital Markets and Securities Authority in Tanzania (CMSA). It was set upestablished on 5th
March 1997 after through the signing of a Memorandum of Understanding (MOU) formally constituting
establishing a framework for mutual cooperation in the area of capital markets development and with a mission to
facilitate the harmonization of securities laws among the East African member states and to promote information
sharing and cooperation among the members. EASRA aimsintends to provide mutual assistance to its member
states in; the development of capital markets institutions, exchanging information to facilitate the enforcement of
their respective laws and regulations, cross border surveillance, public education awareness, co-ordination on
technical assistance and promotion of regional consultancies. This is tackled done with the help of through three
standing committees which are each charged with the task spelt out under the committee name. These are:
i. Legal Issues Committee
ii. Disclosure and Accounting Standards Committee
iii. Market Development Committee
The formationstructure of EASRA was grounded based on the premiseprinciple;
ͻ That securities markets are fundamental to the development of private enterprises, the mobilization of
savings and investments, the efficientwell-organized allocation of resources, and the promotion of
economic growth.
ͻ That international co-operation can facilitatesmooth the progress of the development of effective
operation of securities markets
ͻ That increasing internationalization of securities markets adds new and dynamic dimension to the
economies of all nations.
ͻ That maintaining effective domestic legal and regulatory structures is essential to market integrity and
investor protection.
ͻ EASRA holds meetings every quarter in the three East African countries on a rotational basis.


 
  
( )
The Capital Markets Development Committee (CMDC) was founded established in 2001 and functions operates
under the auspices of the East African Community as one of the standing committees. CMDC membership includes
comprises chief executives of the securities regulatory authorities of the member countries and the chief
executives of the securities exchanges of the member countries. It phrasesformulates policy, develops and makes
recommendation to the council of ministers, regulation and integration of Capital Markets of Kenya, Uganda and
Tanzania. The Committee meets as it deems necessaryindispensable to carry out its mandate from time to time
and to report to the Council at least once a year.

  

 

+
 ã


 

 (ã)
Headquarters in Madrid, Spain, The International Organization of Securities Commissions (IOSCO) has its
headquarters in Madrid and has approximatelyabout 140 members. The three chief objectives upon which IOSCO͛s
securities regulation is grounded based are the protection of investors, ensuring that markets are fair, efficient and
transparent and the reduction of systemic risk.
The benefits of IOSCO membership includecomprise information exchange at an international level, mutual legal
assistance through a multilateral MOU, setting regulatory standards and best practice, resource persons for
training, lower registration fees to events and market recognition. Tanzania is a member of IOSCO.
The member agencies in the International Organization of Securities Commissions have resolved, through its
permanent structures:
ͻ to cooperate together to promote high standards of regulation in order to maintain just, efficient and
sound markets;
ͻ to exchange information on their respective experiences in order to promote the development of
domestic markets;
ͻ to unite their efforts to establish standards and an effective surveillance of international securities
transactions; and
ͻ to provide mutual assistance to promote the integrity of the markets by a rigorous application of the
standards and by effective enforcement against offenses.
Securities listed on the stock exchange(s) have the following advantages:
ͻ The stock exchange(s) provides a fair market place.
ͻ It enhances liquidity.
ͻ Their price is determined fairly.
ͻ There is continuous reporting of their prices.
ͻ Full information is available on the companies.
ͻ Rights of investors are protected.


 

 
 +


The Capital Markets and Securities Authority (CMSA) is a Government Agency constituted established to promote
and regulate securities business in the countryTanzania. It was establishedrecognized under Capital Markets and
Securities Act, 1994.

The legal framework for the regulation of the securities industry is the Capital Markets and Securities Act, 1994
[Act No: 5 of 1994 as amended by Act No: 4 of 1997]. The Act is added onsupplemented by variousa variety of
regulations that are promulgated by the Minister for Finance.

CMSA's Mission is ͙͞to design and implement purposeful measures which will enable the creation and
development of sustainable capital markets that are efficient, transparent, orderly, fair and equitable to all͟.

 ,
 



 
 
 +

ͻ 
 
 ¢ ã


 ¢-**¢  ".ã ¢/¢  01223: An Act to establishset
up a Capital Markets and Securities Authority for the purposes of promoting and facilitating the
development of an orderly, fair and efficient capital market and securities industry in the
countryTanzania, to make provisions w.r.twith respect to stock exchanges, stockbrokers and other
persons dealing in securities, and for connectedassociated purposes.
ͻ 
 
    ã


  (h

  
  *$
 
 "

$

   
 


%

  ) 
  4556.: These Regulations may be referredcited as the Capital Markets and
Securities (Foreign Companies Public Offers Eligibility and Disclosure Requirements) Regulations, 2003 and
shall come into effect from 21st May, 2003
ͻ 
 
    ã


  (h

  
  *$
 
 "

$

   
 


%

  ) 
  4556 -   
 4551/: These Regulations facilitates provide for the
participation in the capital markets by foreign issuers of securities, in terms of the eligibility criteria and
the disclosure needs requirements for such companies to make public offers or cross list at the Dar es
Salam Stock Exchange.
ͻ 
 
    ã


  (h

    
) 
  4556: These Regulations set outspecify
the limit of aggregate securities to be held by foreign investors. These Regulations also prescribeset down
the manner and conditions under which foreign investors will participate at the Dar es Salam Stock
Exchange, the mechanism by which the Authority can monitorkeep an eye on observance of the
prescribed limits by the Dar es Salam Stock Exchange SE and Central Depos
ͻ 
 
    ã


  (  

+
    
    ) 
  4555: These
Regulations set outspecify the disclosure requirementsnecessities that an issuer is obliged to comply with
during capitalization by way of Rights Issue.
ͻ 
 
    ã


  (
    ã  ) 
  227: To supplementadd-
on the Capital Markets and Securities Act, these Regulations make detailedthorough provisions
relatingconcerning to the roles of managers, trustees, schemes, trust deeds, pricing, issue and redemption
of units / shares and other relevant matters.
ͻ 
 
    ã


  (   r
 ) 
  227: The Conduct of rusiness list
rules on conduct including comprising inducements, churning, customer right, confidentiality, charges,
 execution in addition to the conductmanner of business provisions provided in the Capital Markets and
Securities Act.
ͻ 
 
    ã


  (¢

  ) 
  227: These Regulations relate to the
vetting of securities advertisements by the Authority and it provides for a number of rules and norms
conditions that have to be met by advertisers in the securities business. These rules and norms comprise
Conditions include the requirement for the content and presentation of the advertisement. The
advertisement has to be factual, that is comparison or contrasting of investment should not be done
unless it is fair, or it should not contain unfair or otherwiseor else misleading matters or it should not
exaggerateoverstate the success or performance of the company.
ͻ 
 
    ã


  (¢ 
   h
 
 %

  ) 
  227: These
Regulations provideendow with for the maintenance of accounting records (comprisingincluding audit
trail), preparation of the annual financial statements as well of treatment of customer money in
accordanceharmony with the law (i.e. in trust for the client). These Regulations were amended in 2003 to
compriseinclude provisions for penalties in case of non-compliance on the part of dealers. These
Regulations supplement provisions on accounts and audit, which are containedenclosed in the Capital
Markets and Securities Act.
ͻ 
 
    ã


  (*
   %

  ) 
  227: These Regulations
supplementadd-on the general provisions on public issues of securities which are contained in the Capital
Markets and Securities Act. The prospectus is an importantsignificant document which is
requirednecessary where a public offer is being made. The items requirednecessary to be comprised
included in the prospectus are listed in the Regulations. These includecomprise matters to be stated in the
first page of the prospectus. Others includecomprise information on the right of holders, information on
bankers, capital of the issuer, debt of the issuer, any material contracts, the use of the proceedsprofits
from the issue etc.
ͻ 
 
    ã


  (
 
) 
  228: These Regulations set outspecify the
proceduresmeasures to be complied with by the applicants for licencing for exampleinstance dealers,
investment advisers or their representatives. The requisitenecessary application forms are prescribedset
in the Regulations. General conditions relating to licences once obtained are also provided for, comprising
including the provision that the licence shall be personal to the applicant and the requirementobligation
for a licencee to inform the Authority (by written notice) of any relevant alterations.
ͻ 
 
  ã


 (" $
 ã"  )
 228: These Regulations
provideoffer for procedures for the establishmentinstitution of a Stock Exchange. Applications for
establishmentfounding of a Stock Exchange are to be made by a corporate body to the Authority, which
grants approval subject to certain conditionsstate of affairs, and will continue to regulate the stock
exchange once it is approved.
ͻ 
 
    ã


  (

   
  
 ã


 ) 
  228: Certain market
players are requirednecessary by the Act to maintain a register in the prescribed form of the securities in
which he / she has an interest. These Regulations thereforehence includecomprise the prescribed forms
as well as a provision for varying of the form of register by the Authority where necessary. The registers of
interest in securities enable transactions to be easily traceable by the Authority and other interested
parties thus providing the requisitenecessary transparencylucidity in securities transactions.
ͻ 
 
  ã


 ¢ 

" 
 .

 4553: These Guidelines set outspecify
the practices and procedures to be followed by the CMSA while en doing conducting investigations or
inquiries where there is breachviolation of the law by market participants or otherwise.
ͻ 
 
    ã


  ã   ã

 ã 
        4556: In
February 2003, the Authority approved the Capital Markets and Securities Authority Scheme of Service,
Staff Regulations and Code of Conduct to among other things guide the affairs of its staff, carrying
outexecution staff procedures and to set out criteria governing salary entry points, the mode of
movement from entry point to retirement and the criteria for movement.
ͻ 
 
    ã


  ( 
   
 ) .

  4554: The Guidelines aimintend at
offering giving members of the Authority and employees of the CMSA a framework within which to deal
with conflicts of interest and other related matters. They are also intendedanticipated to protect
members of the Authority and employees of the CMSA against any suggestions that regulatory decisions
 have been affected influenced by personal interests or that their investment decisions are made by using
insider information. These Guidelines consist of include general principles on conflicts of interest, the
policy on employees͛ interests, securities transactions by employees and Authority members, treatment
of gifts and consequences of default.
ͻ 
 
  ã


 (

.
 ).

 4554: These Guidelines aimintend to
improve at improving and strengthening corporate governance practices by issuers of securities through
the capital markets and promote the standards of self-regulation so as to raise the level of governance in
line with global international trends. The Guidelines have been issued in view of the role that good
governance has in corporate performance, capital formation and maximization of shareholders value in
addition to protection of investors͛ rights. The Guidelines apply to public listed companies and any other
issuers of securities through the capital markets comprising including issuers of debt instruments.

ͻ .

  
       

 r     

 *
 222: These Guidelines set
outspecify the disclosure requirementsnecessities that an issuer is obliged to complyobey with when
applying for issuance of a Corporate rond or a Commercial Paper.
ͻ 
 
  ã


 ( 
 ã


 )
 4558: These regulations may be seen
cited as the Capital Markets and Securities (Custodian of Securities) Regulations, 2006.
¢


 
 ã 
 


1. Trading of securities
2. Risk management
3. Clearing and settlement of trades
4. Delivery of securities and funds

ãc *¢9"ã "

Consumption fulfills individuals͛ immediate needs. Sometimes the distinction between consumption and
investment is not easy to make. Educational expenditures often are made to increase the quality of life and thus
have a consumption element. rut education also increases individuals͛ ability to produce goods and services and
therefore can be, and often is, considered to be production.

Individuals must consume to survive. Individuals consume a variety of products. The types of items consumed and
the quantity consumed vary widely from country to country. Consumption also differs from individual to individual
even within the same country.

ãc *:#¢*"h"¢*¢  ¢!"

We consider a simple 2-period world in which a single consumer must decide between consumption 0 today (in
period 0) and consumption 1 tomorrow (in period 1). Our consumer is endowed with money 0 today and 1
tomorrow. Consistent with his endowment, the consumer has the opportunity to borrow or lend 0 today at
interest rate
.

The equations governing the consumer͛s feasible actions today and tomorrow are:

0 M 0 + 0 (1)

1 M 1 ʹ (1+
)0. (2)

It is understood that consumption in both periods must be nonnegative, which puts limits on how much the
consumer may borrow or lend today, namely, ʹ0 ч 0 ч 1/1+
. After substituting 0 ʹ 0 for 0 in (2), the
consumer͛s 
 
 
 |
 È È |
  (3)
|È  |È 

We have written the budget constraint as an equality since we shall assume our consumer always prefers more
consumption. We interpret the symbol Ä0 as the consumer͛s


  
 
 . Note that consumer͛s future
value of wealth Ä1 would be (1+
) Ä0.

To determine the optimal consumption and borrowing plan, we posit a consumer utility function
(0, 1) of the
form optimal consumption and borrowing plan, we posit a consumer utility function
(0, 1) of the form
ഁ
ξܿͲǡ ൅  ξܿͳ. As we shall see, the parameter ɴ serves as a discount factor on future consumption. Smaller values
of ɴ imply a larger discount factor on future consumption, which implies that our consumer prefers more
consumption today.

Formally, the consumer͛s optimization problem is given by:

௖
‫ܺܣܯ‬ሼܷሺܿ଴ ǡ ܿଵ ሻ ‫ܿ  ׷‬଴ ൅ ଵା௥
భ
ൌ ܹ଴ ሽ (4)

which may be equivalently expressed as

‫ܺܣܯ‬൛ܷ൫ܿ଴ ǡ ܿଵ ሺܿ଴ ሻ൯ ‫ Ͳ ׷‬൑ ܿ଴  ൑ ܹ଴ ൟǡ (5)

where

ܿଵ ሺܿ଴ ሻ ؔ ሺͳ ൅ ‫ݎ‬ሻሺܹ଴ Ȃܿ଴ ሻ (6)

The form of utility implies that consumption in both periods must be positive so that the optimal choice for 0
necessarily lies strictly between 0 and Ä0. Accordingly, first-order optimality conditions imply that

ௗ௖భ ଵ ఉሺଵା௥ሻ
0 M ௖ ൅  ௖ ൌ మ െ
 
మ ௖ (7)
బ భ ௗ௖బ ඥ௖బ ξ భ

From (7) the optimal consumption plan necessarily satisfies the condition

௖
ට௖ ൌ ߚሺͳ ൅ ‫ݎ‬ሻǡ
భ
(8)
బ

or, equivalently,

ܿଵ ൌ  ߚଶ ሺͳ ൅ ‫ݎ‬ሻଶ ܿ଴ (9)

Substituting (9) into the budget constraint (3) and solving for ܿ଴ and ܿଵ , the optimal consumption plan is
given by:

|
      (10)
|È

| È  
 h
|
 

|     | (11)
|
h
|
 

It is important to point out here that the constants 0 and 1 are independent of present wealth W0; that is, they
are known parameters strictly determined by the two discount factors and
. Note further that the optimal utility
is of the form

c       È |   (12)

": Suppose 0 M 100, 1 M 990,
M 0.10 and M 0.60. Then 0 M 0.716Ä0, 1 M 0.312Ä0 and
*(Ä0) M 1.182
ඥܹ଴ . Here Ä0 M 100 + 990/1.1 M 1000. Thus 0 M 716, 1 M 312 and
*(1000) M 37.36. Due to the availability of
capital market at which to borrow or loan, the consumer has increased his utility by almost 30% above the level
corresponding to the initial endowment
(100,900). To obtain the optimal consumption plan, the consumer must
borrow 0 M 716 ʹ100 M 616 today, pay back 678 tomorrow, thereby leaving him with 990ʹ678 M 312 to consume in
the final period.

ãc *¢9"ã ":#¢*"h"¢*¢  ¢!"

No we will take into account a world in which the consumer now has the opportunity to invest O0 today in
production from which he will receive (O0) tomorrow. The function (O0) encapsulates the investment opportunities
in production available to our consumer. For example, the consumer may wish to obtain an education while he is
young, expecting a return on this investment in his working years. It is generally assumed that (.) is strictly
increasing (more investment leads to more return) but exhibits diminishing returns in that the marginal return on
an incremental rise in investment declines as the total investment increases. When f(.) is differentiable, these
assumptions imply the first derivative is positive and the second derivative is negative. (Such a function is called
concave). To ensure at least some investment would be made (to make our subsequent calculations easier), we
also assume that the derivative ͛(0) is infinite.

The equations governing the consumer͛s feasible actions today and tomorrow are now:

0 + O0 M 0 + 0 (13)

1 M 1 +(O0) ʹ (1+
)0. (14)

Rearranging terms as we did before, the new budget constraint is

|   
 È  È
   (15)
|È  |È 
A close examination of (15) reveals a fundamental property: All consumers, regardless of their utility function,
should first determine the optimal investment plan to increase their wealth! That is, they should select the value of
O0 such that the marginal return f͛(O0) M 1 +
. When the function (O0) represents the investment opportunities for a
firm in which consumers hold stock, then each consumer that holds stock would insist that firm optimize its
investment opportunity, regardless of each consumer͛s different desires for consumption today versus tomorrow.
recause there exists a capital market for each consumer to borrow or lend, each consumer can redistribute the
increase in wealth as they desire. This principle (in various forms) is known as the Fisher Separation Theorem of
Finance.
" 4: Suppose (O0) M 33 ඥ‫ܫ‬଴ Ǥ Now ͛(O0) ¢¢
మඥ‫ܫ‬଴ ሿǡ and so the optimal choice for O0 M225. The additional
wealth created through investment equals 195/1.1 ʹ 225 M 225 so that ܹ ෡଴ ൌ ͳʹʹͷǤ From (10) and (11) the optimal
consumption plan is 0 M 877 and 1 M 382 with
*(1225) M 41.34. The utility has increased by about 10.7%, which
also corresponds to 100(ඥͳʹʹͷ ͳͲͲ ʹ 1). To obtain the optimal consumption plan, the consumer must borrow 0
M 877 + 225 ʹ 100 M 1002 today, pay back 1103 tomorrow, thereby leaving him with 990 + 495 ʹ 1102 M 382 to
consume in the final period.

ãc *¢9"ã ":#c¢¢*¢  ¢!"

We now consider the situation in which the consumer has investment opportunities as described in the previous
section, but no longer has the opportunity to borrow or loan, i.e., 0 M 0. We shall see that without access to a
capital market our consumer is far worse off.

The equations governing the consumer͛s feasible actions today and tomorrow are now:

0 + O0 M 0 (16)

1 M 1 + (O0) (17)

The new budget constraint may be represented as:

1(0) M 1 + (0 ʹ 0) (18)

The first-order optimally conditions (7) imply that

௖
ට௖ ൌ ߚ݂ ᇱ ሺ‫ܫ‬଴ ሻǡ
భ
(19)
బ

or, equivalently, that the optimal choice for O0 must satisfy the identity

௠భ ା௙ሺூబ ሻ
ට ௠బ ିூబ
ൌ ߚ݂ ᇱ ሺ‫ܫ‬଴ ሻ (20)

After substituting the specific choice for  and performing simple algebra, the optimal choice for O0 must satisfy the
identity

ଽ଼଴ଵ
ââͲ ൅ ¢¢ට‫ܫ‬଴ ൌ  െ â ǤͲͳ (21)
ூబ

Since the left-hand side of (21) is an increasing function of O0 that is finite when O0 M 0 and the right-hand side of
(21) is a decreasing function of O0 that is infinite when O0 M 0, a unique solution exists, which may be obtained by
bisection search. (Alternatively, identity (21) is essentially a cubic equation, which has a closed-form solution.) The
optimal value for O0 is about 8.25 with a corresponding consumption plan of 0 M 91.75 and 1 M 1085 with
* M
29.34. The utility has dropped considerably to almost the level corresponding to the original endowment.

¢!"* ¢"㢢ã¢ããã

While mostthe majority neoclassical economists gave their attention focused during the early part of the
twentieth century on modeling production costs in a general equilibrium framework using Cobb-Douglas
production functions, Coase (1937) came up with his seminal ideas on the nature of the firm using
partial equilibrium analysis. He viewed cited the significance importance of systems attributing
transaction cost as one of the key concepts in economic analysis. His ideas along with together with
Williamson (1985) built the foundation of what is now known as transaction cost economics with
empiricalexperimental works in comparative institutional analysis and management. Transaction cost
economics is also consideredwell thought-out to have extensive influence on industrial organization
economics and management. The same can be said of contract theory which analyzes economic
behavior of agents in resource utilization against the backdrop of tradeoffs among various transaction
costs such as information, bargaining, monitoring, and agency costs. Williamson (1985) had defined a
transaction as the transfer of a good or service across a technologically separable interface, and yet
transaction cost economics researchers continue to ignore the significance of interfaces.
An relatedassociated concept is that of modularity. Entities with defined interfaces are known as called
͞modules͟ and modularity as a structure of systems has been researched in various fields after the IT
industry͛s success widelyextensively attributed to the deployment of modularity in industry and product
design structures. A module is commonlygenerally defined as a unit sharing multiple interfaces to
interact, integrate and combine; but the term interface is referred to in very few studies of modularity.
Modularity existing beyondfurther than the boundary of organization can be explained by analyzing its
different various interface aspects. As a common general systems concept, modularity has a strong
affinity with organization theory and has broad implications vis-à-vis outsourcing and contract
manufacturing, the network organization structure in Silicon Valley and so forth. In some studies,
findings show that almostapproximately all systems are, to some extentdegree, modular. Without
questionNo doubt, automobile manufactures have been using a number of numerous modular
components. HoweverNevertheless, various many researchers such as Clark & Fujimoto (1990) focus on
their non-modular coherent structure as the most significant important success factor of these
consumer durables. There is a indispensable significant requirement need for issues associated with the
related to complexity to be further analyzed.
In spite ofDespite its ever growing increasing popularity, neverthelesshowever, there exists no perfect
accurate definition of modularity yet. Even in the most accepted definition which states that a module is
a unit with elements that are ͞relatively͟ tightly and coherently coupled/connected inside and
͞relatively͟ loosely and weakly outside, that relativity is still shrouded with ambiguity and needs to be
expounded further. SubstantialConsiderable transaction costs accrue as interfaces are established and
used, and investigating the transaction costs mechanism necessitates requires carefulcautious study of
the interfaces involved.
We hereby focus on the common characteristicfeatures observed by researchers of both transaction
cost economics and modularity which is interchangeabilitysubstitutability, transferability, fungibility, or
redeployability, and propose to introduce the notion of interface (transaction interface) to further
analyze these issues. Interface is defined as the parameters/media through which transactions are made
between two entities. Our aim purpose here is to develop a model for understanding the mechanism of
interfaces from the transaction cost approach. In present day͛s today͛s network era, growth is heavily
determineddogged by the ability or capacity of an entity (any individual, organization or economy) to
absorb, utilize and exchange resources through interfaces that play importantsignificant roles. We
believe that the necessity ed to study interfaces has been increasing especiallyparticularly with the
proliferation of economic activities over the Internet which not only allows high-speed transmission of
information but also facilitates collaboration between the entities involvedconcerned in a transaction.

 
  
After Coase (1937) laid downestablished a niche for the concept of transaction costs in economics,
Williamson and several other scholars researched explored the concept further. ͞Transaction costs are
arguably the most important set of prices in an economy͟. In the modern world, it would be difficult to
find a rich country where transaction costs sum up to less than half of national income͟ estimated the
overall size of the transaction sector 1970 as about 45 percent of the U.S. gross national product. The
concept of transaction costs is not only crucial in economics, but also is regarded considered as the
backbone for the explanations of international organizations.
The definition of transaction costs still varies have different meanings among different fields and there
have been very few empirical studies on comparative measurement or measurement itself due to the
problem. Dahlstrom and Nygaard warn that transaction cost economics ͞cannot survive another 30
years without empiricalpragmatic measurement of the key theoretical element, namely, ͞transaction
costs.͟
Coase defines transaction costs as ͞the costs of using the price mechanism, which includes the costs of
discovering relevant prices, and negotiating and concluding contracts͟ and ͞the costs of resources
utilized for the creation, maintenance, use, and change of institutions and organizations͟ which
includecomprise the costs of defining and measuring resources or claims, the costs of utilizing and
enforcing the rights specified, and the costs of information, negotiation, and enforcement.
According to Williamson (1985), transaction costs include the ex ante costs of drafting, negotiating, and
safeguarding an agreement, and the ex post costs of haggling, costs of governance, and bonding costs to
secure commitments. Alchian & Woodward asserted that Williamson͛s focus is mainlychiefly on
contractual issues such as administrating, informing, monitoring, and enforcing contracts, not on market
exchange issues such as finding other people, inspecting goods, seeking agreeable terms, and writing
exchange agreements. They define it as ͞the costs incurred in exchange transactions comprising
involving the transfer of property rights and contracting transactions involving negotiating and enforcing
promises about performance.͟
Arrow (1969) refers to transaction costs as ͞the costs of running the economic system.͟ The following is
a running list of definitive statements on transaction costs in different various studies.
! ͞the costs of processing and conveying information, coordinating, purchasing, marketing,
advertising, selling, handling legal matters, shipping, and managing and supervising.͟ (Wallis and
North, 1986).
! ͞those costs associated with ͚greasing markets,͛ including the costs of obtaining information,
monitoring behaviour, compensating intermediaries, and enforcing contracts.͟ (Davis, 1986).
! ͞the cost of arranging a contract ex ante and monitoring it ex post, as opposed to production
costs, which are the costs of executing a contract.͟ (Matthews, 1986).
! ͞all the costs which do not exist in a Robinson Crusoe economy͟ as it is difficult to separate one
type of transaction cost from another. (Cheung, 1988).
! ͞the costs associated with the transfer, capture, and protection of rights.͟ (rarzel, 1989).
! ͞the costs that arise when individuals exchange ownership rights to economic assets and
enforce their exclusive rights.͟ (Eggertsson, 1990).
! ͞those (the costs) involved in the transfer of goods and services from one operating unit to
another͙.they usually involve the transfer of property rights and are defined in contractual
terms.͟ (Chandler and Hikino, 1990).
! ͞the costs of defining and measuring resources or claims, plus the costs of utilizing and
enforcing the rights specified͟ when considered in relation to existing property and contract
rights; and, quoting Coase (1960), the definition includes ͞costs of information, negotiation, and
enforcement͟ when applied to the transfer of existing property rights and the establishment or
transfer of contract rights between individuals (or legal entities).͟ (Furubotn and Richter, 1997).
! ͞the costs of running the systems: the costs of coordinating and of motivating.͟ (Milgroom and
Roberts, 1992)
 ! ͞the sum of the costs associated with engaging in exchange and contracting activities, which are
distinct from the costs of production͟ (Polski, 2001). The transaction costs at plant, however, are
not easily separable from production costs considering that what Eggertsson (1990) designates
the costs of production in the neoclassical model are not well defined.
! ͞the costs of acquiring and handling the information about the quality of inputs, the relevant
prices, the supplier͛s reputation, and so on.͟ (Vannoni, 2002).
The list above shows indicates that the costs for contract and information are comprises included in all
the definitions above, but ordering/invoicing, clearing/settlement, transportation, switching activities
such as training/education, integration and management, infrastructure and media have not been
clearly specified by any of the above-mentionedaforementioned researchers. Polski (2001) pointed out
͞North (1990,1997), Wallis and North (1986), and Williamson (1985, 1999) have all argued that
transaction costs are embeddedset in in layers of governance structures,͟ so that it is not easy to
separate and define transaction costs explicitly.
Clearing and settlement, howevernevertheless, are consideredwell thought-out importantsignificant
procedural components of an exchange particularly those comprising involving financial or cash
transactions. On contrarythe other hand, ordering tend to have a non-specific nature for the reason that
because it is deemed as a kind of contract. Contacts essentiallyfundamentally designate the conditions
of exchange, howevernevertheless, these do not necessarilyessentially includecomprise the execution
orders of the exchange that are clearly based on the occurrence of ordering and invoicing.
The complexintricate nature of transportation has proved to be challenging to previous researchers
becausefor the reason that physical flow seems to be separabledivisible from information flow. Cheung
(1998) excluded the transportation costs and production costs from transactions costs because he
considered these to be physical while Wallis & North (1986) included the transportation costs as
͞shipping costs.͟ If we define an exchange as a transfer of goods or services and related information, it
stands to reason that a transaction may be defined as an exchange with a corresponding order of
sequential activities required to complete the exchange. Grounded rased on this specificationcondition,
our concept of transaction comprises includes transportation by definition. MoreoverFurthermore, it
attributes transportation costs to ͞site specificity͟ which plays an importantsignificant role in
transaction cost economies.
In additionAdding together, information flow in transportation such as receiving, tracking, expediting,
data processing, accounting, etc., are quite often embedded in the transportation itself and not
separable. The costs incurred in moving cargo or changing the location coordinates of plant
infrastructure, whether through manual or mechanical means within organization, are most often
reflected in management costs. In some instances, the physical transfer or logistical movement of a
good signifies the completion of an exchange and in that case, transportation is considered an
information flow as well. Physical flow of money is a good example. Some transportation costs are
inseparable from the well-accepted nation of ͞transaction costs͟. Furthermore, it is an important cost
factor to be considered with regard to the decision of executing transactions and should be given careful
consideration.
The switching costs related to such activities as training/education, management and business process
integration for a newly deployed good/service influence decision on transaction execution as a cost
factor and, for that reason, need careful analysis as well. Furubotn and Richter (1977) called attention to
political transaction costs and managerial transaction costs along with market transaction costs. Political
transaction costs include ͞the costs of setting up, maintaining and changing a system͛s formal and
informal political organization͟ and ͞the costs of running a polity͟. Managerial transaction costs reduce
͞the costs of setting up, maintaining or changing an organizational design͟ and ͞the costs of running an
organization.͟ Williamson (1985) also included accounting and control systems as well as monitoring
systems. The switching cost is considered to be an internal enforcement cost while costs incurred in
enforcing compliance measures involving external entities are widely-accepted to be included in
transaction costs. Therefore, costs of this nature should be included in the transaction costs.
Infrastructure and media are indispensable for the transfer of information and physical objects to occur.
For instanceexample, contracts may be sent via the post under the pay per use setup. Alternatively,
information can be exchanged via the internet, by using a monthly leased dedicated line, or even by
building one͛s own communication line or network. Investing in the acquisition of telecom equipment
such as digital telephone switches, routers, servers, etc. is often required. In the case of pay per use, it is
easily measurable as a transaction cost but the allocation of infrastructure cost, such as durable goods
and equipment as well as media cost are embedded and not easily distinguishable. The same can be said
of management costs which are highly intangible and are most often dealt with in conventional
accounting systems as part of overhead or as a bulk of miscellaneous costs. Most of these are often
embedded by nature but comprise involve significantimportant friction factors that merit careful
analysis.
So we recognize transaction costs as all the costs incurred needed to complete exchange related with
the transfer of a physical object and information, including the costs of ordering/invoicing,
clearing/settlement, transportation, switching activities such as training/education, integration, and
related management, and infrastructure and media. Money transfer is divided into and included in
physical and information transfer.
¢ã¢ããã¢#"r"¢!:hã"*¢¢
If transaction costs are nigglingnontrivial, financial intermediaries and marketplaces will providesupply a
useful service. In such a world, the borrowing rate will be greater than the lending rate. Financial
institutions will pay the lending rate for money deposited with them and then issue funds at a higher
rate to borrowers. The difference between the borrowing and lending rates represents their
(competitively determined) fee for the economic service provided. Different borrowing and lending
rates will have the effect of invalidating the Fisher separation principle.
The theory of finance is greatlyvery much easy to understand simplified if we assume that capital
markets are perfect. ObviouslyEvidently they are not. The relevant question then is whether the
theories that assume frictionless markets fit realityactuality well enough to be useful or whether they
need to be refinedpolished in order to providegive greater insights.

ãc ¢;

The objective of this chapter was to study consumption and investment decisions made by individuals
and firms and to understand the role of interest rates in making these decisions. The decision about
what projects to undertake and which to reject is perhaps the single most important decision that a firm
can make. Logical development is facilitated if we begin with the simplest of all worlds, a one-
person/one-good economy with no uncertainty. The decision maker must choose between consumption
now and consumption in the future. Of course the decision not to consume now is the same as
investment. The decision is simultaneously one of consumption and investment. In order to decide, he
needs two types of information. First, he needs to understand his own subjective trade offs between
consumption now and consumption in the future. This information is embodied in the utility and
indifference curves. Second he must know the feasible trade offs between present and future
consumption that are technologically possible. From the analysis of an economy we will find that the
optimal consumption/investment decision establishes a subjective interest rate for the individual and
the economy as a whole.
"9":<c"ãã

1. Jones is endowed with money 0 M 55,000 today and 1 M 88,000 tomorrow. He desires to
consume 0 M 80,000 today and 1 M 66,000 tomorrow.
(a) If there is no opportunity to borrow or lend can Jones achieve his consumption objective?
Explain?
(b) Suppose there is a perfect capital market in which Jones may borrow or lend as much as he
desires at the market interest rate of 10%. Can Jones now achieve his consumption
objective? Explain.
(c) Suppose that in addition to a perfect capital market Jones has an opportunity to invest O0 M
100,000 today and receive (O0) tomorrow. Determine the minimum value for (O0) for which
Jones will be able to exactly achieve his consumption objective.
(d) Explain exactly what Jones must do using the capital market and investment opportunity
available to him so that he may exactly achieve his consumption objective.
2. Jones is endowed with money 0 M 40,000 today and 1 M 99,000 tomorrow. He desires to
consume 0 M 100,000 today and 1 M 55,000 tomorrow.
(a) If there is no opportunity to borrow or lend can Jones achieve his consumption objective?
Explain.
(b) Suppose there is a perfect capital market in which Jones may borrow or lend as much as he
desires at the market interest rate of 10%. Can Jones now achieve his consumption
objective? Explain.
(c) Suppose that in addition to a perfect capital market Jones has an opportunity to invest I0 M
55,000 today and receive (O0) tomorrow. Determine the minimum value for (O0) for which
Jones will be able to exactly achieve his consumption objective.
(d) Explain exactly what Jones must do using the capital market and investment opportunity
available to him so that he may exactly achieve his consumption objective.
3. Smith͛s utility function is
(0, 1) M ln 0 + 0.4 ln 1. Smith is endowed with money 0 M 90,000
today and 1 M 500,000 tomorrow. There is a perfect capital market for borrowing and lending
at the market rate of interest of 25% per period.
(a) Determine the optimal consumption plan for Smith. Explain exactly what Smith must do
ௗ
each period to achieve his optimal consumption plan. (Recall that ௗ௫ ݅݊‫ ݔ‬ൌ ͳ ‫)ݔ‬
(b) Smith has an opportunity to invest I0 M 80,000 today and receive (O0) M 135,000 tomorrow.
Should he take advantage of this opportunity? If not, explain why not. If so, explain exactly
what he should do each period to achieve his new optimal consumption plan.
(c) If Smith no longer has access to the capital market (he cannot borrow or lend), then should
he take advantage of the investment opportunity presented in (b)? Explain your reasoning.
4. Suppose that the investment opportunity set has N projects, all of which have the same rate of
return, R*. Graph the investment opportunity set.
5. Suppose your production opportunity set in a world of perfect certainty consists of the following
possibilities.
*
&     
 
(=)
 A TZS1,000,000 8
r 1,000,000 20
C 2,000,000 4
D 3,000,000 30
(a) Graph the production opportunity set in a 0,1 framework.
(b) If the market rate of return is 10%, draw in the capital market line for the optimal
investment decision.

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The market is a central building block in the edifice of modem economic theory. Usually pictured as the demand
curve crossing the supply curve, the market in standard economics textbooks is free of any institutional structure.
Simply reduced as a price-making mechanism, the market serves more as a theoretical construct than as a
characterization of the actual process of exchange. Recent development in new institutional economics has drawn
much attention to empirical studies of economic institutions. rut the emphasis is largely laid on the institutional
structure of production, particularly business firms. The institutional structure of exchange is unfortunately
overlooked. What Ronald Coase bemoaned more than a decade ago still remains a disturbing reality, "Although
economists claim to study the working of the market, in modern economic theory the market itself has an even
more shadowy role than the firm" (1988a, 7).

Overlooking the institutional structure of the market leads economists to take the existence of the market for
granted. Nothing more than "the law of supply and demand" is required for economists to reach a conclusion on
their blackboard that the price mechanism (i.e., the market) is at work. The economists hence seldom bother to
investigate how the market as an economic institution emerges and develops in the real world. Even new
institutional economists who are committed to studying real life economic institutions are inclined to assume that
"in the beginning there were markets" (Williamson 1975, 20; 1985, 87). A casual perusal of the real world,
however, makes it clear that this view does not square with the reality. No market is not deliberately created or
costly to maintain, be it the Chicago Mercantile Exchange or a Chinese fish market. Taking the existence of the
market for granted makes us blind to underlying economic forces that shape the institutional structure of
exchange.

Over the past couple of decades, one of the most influential concepts brought into economists' tool-kit is
transaction cost (Coase 1937). Admitting the existence of transaction costs helps economists move out of their
imaginary world and come down to the reality. In the real world, we can not help but realize that transaction costs
are ubiquitous. Without transaction cost as the tool of the trade, it is no wonder that economic analysis in the past
was out of touch with real world economic activities. Ever since the introduction of transaction costs, economists
have made considerable progress in understanding real world economic institutions, particularly in the field of
business firms. It is surprising however that the market--another economic institution of equal if not more
significance--has received scant attention.
This paper applies the same approach that has proved to be quite productive in the study of the firm to investigate
the working of a real world market. rased upon the development of fish markets in a Chinese fishery community,
this paper directs our attention to the institutional structure of exchange. It empirically shows that not only the
institutional structure of the market is a response to the cost of carrying out transactions, but the very existence of
the market is contingent upon entrepreneurial calculations. In doing so, this paper advances our understanding of
the choice between the firm and the market in organizing economic activities for the sake of reducing transaction
costs.

 '
h
 
 

The fieldwork for this case study was done in the Long Lake area, Hubei province, China. Well known in China as
the "land of fish and rice," this area abounds with lakes, ditches, and ponds, which provide favorable natural
conditions for freshwater fishery. In spite of rich natural resources, the development of a large scale freshwater
fishery did not start until the late 1970s when rural economic reforms were initiated. In the pre-reform era, fishing
was exclusively for self-consumption because private commercial activities were largely banned. Under the
socialist planned economy, there were virtually no market transactions. In the wake of rural economic reforms, the
ban on commercial activities was lifted. "Rural petty commodity markets" were encouraged by the reform policy to
cater to the increasing needs of the rural population. The opening of fish markets quickly commercialized fishing
and peasant-fishermen began to sell their catches in markets for cash. High profits in fishing stimulated the steady
growth of freshwater fishery, which in turn pushed for further market integration.

Fish markets in this region are connected and organized into a hierarchical network. At the bottom of this
hierarchy are fishing grounds (e.g., lake shores or fishponds), which are drawn as squares, where fishermen sell
their catch. At the top are fish markets in Jingzhou, the prefecture city in this region, where city residents and
other consumers buy fish. These fish markets are represented as a big rectangle. In between are intermediate
markets, which are located in local towns more or less away from Jingzhou. In the figure, intermediate markets are
drawn as ellipses. In this network, the flow of fish starts at the bottom, i.e., fishing grounds, and ends up at the
top, i.e., fish markets in Jingzhou. The transportation of fish from the fishing grounds to the final fish markets is
carried out by middlemen whose entrepreneurial activities of buying cheap and selling high help to bridge spatially
distanced producers and consumers.

The group of middlemen is heterogeneous. Local terms define two types of middlemen, "moving middlemen" and
"sitting middlemen." A sitting middleman has a fixed shop in a market. He buys fish in wholesale and retails to
individual consumers. recause city residents are the primary group of consumers, most sitting middlemen are in
the city. And there are few sitting middlemen at intermediate markets. A moving middleman travels to fishing
grounds or intermediate markets to buy fish and sell to other moving middlemen or sitting middlemen in the city.
A moving middleman moves back and forth between different marketplaces, and that is how he earns his name of
"moving" middleman. recause fish transportation is a rather arduous task, many moving middlemen work in small
groups, which usually consist of two or three middlemen.

To introduce this network of markets, we start with fish markets in Jingzhou. As the biggest city in this region with
a population of 330,000, Jingzhou has many permanent "vegetable and food markets" in its residential districts
where city residents and retailers freely bargain and make exchange transactions. The marketplace is usually
housed in a big hall, separated into many sections. Each section is reserved for one type of goods, such as rice,
vegetables, fruit, pork, beef, chicken, or fish. The separation of the marketplace into specialized sections certainly
helps consumers reduce their search time when they do shopping. In each section, there are many retailers selling
the same type of (certainly not identical) goods and competing against each other for customers. A retailer rents a
numbered shop place from the administration office in charge of the marketplace. In most marketplaces, what a
retailer rents is actually not a shop, but a counter or just a small area of the floor in the market hall to dis play their
goods. After paying a fixed amount of monthly sales tax, the retailer is then licensed to operate. In addition to
retailers with fixed shops, there are also occasional retailers. These retailers sporadically sell goods in the market,
and do not have a fixed shop place. Occasional retailers are usually peasants who sell their extra agricultural
products after consumption. Though entry to the market is not restrained, occasional sellers are required to pay
sales tax. However, the amount of tax is not clearly defined, but subject to the arbitrary decision of the market
administration office. As a result, tax avoidance on the part of occasional sellers is the rule rather than exception.
When they get caught, their goods are usually confiscated or destroyed if the administration officials refuse to take
bribes.

In the marketplace, the area of fish shops is usually wet and filthy. Since fresh fish taste much better, most fish are
sold alive in the market. Dead fish have a much lower market value. To be kept alive, fish are usually stored in an
open container filled with water. Fish of the same species are sorted into one container. Some sellers even build a
large container with bricks and keep all their fish together. Depending on the way (i.e., what equipment was used)
that fish were captured and transported, as well as their species, fish can be kept alive in a container for one to
several days. In a large brick-built container, which is usually equipped with running water, fish can live much
longer.

Though the marketplace remains unlocked overnight, the daily schedule of the market starts around five in the
morning when first retailers arrive, carrying their goods. After their arrival, retailers begin to display their goods on
the counter, waiting for customers. The first customers usually arrive around six. In the beginning, there are not
many shops open. Frugal customers usually visit all the open shops one by one, haggling around, and then buy
from the one offering the best price. The price differs considerably between shops in the beginning, even for fish
of the same species, size and quality. The price information is then communicated to each one of retailers by price-
seeking customers. After a while retailers begin to adjust their price levels to attract customers. And the price
levels gradually converge. However, this does not mean that the price level stays the same. As more and more
customers visit the market, the price gradually increases at almost the same pace across the whole market. In
general, the fish price in the morning (between seven and nine o'clock) records the highest. This is not without
reason. From the demand side, the morning market has the most local consumers, since most city residents do
their shopping before they go to work at eight o'clock. On the supply side, fish are most fresh. After eight, the
number of customers decreases sharply and the fish price drops accordingly. After noon, there is a considerable
drop in fish price, usually about ten to fifteen percent, partially because some fish can no longer be kept alive and
are sold cheap. Prior to the close of the market in the early evening, retailers are eager to sell out their remaining
fish, especially those that can not live to the next day, so that the fish price is usually the lowest at this time.

Compared with the market in Jingzhou, the intermediate market in the local town is much smaller, in terms of both
its physical size and the number of participants. In general, the larger the town population and hence the
consumer group, the bigger the marketplace. The majority of the marketplaces in towns are outdoors. The main
street of the town usually serves as the temporary marketplace. Sellers just display their goods along the street,
haggling with people passing by. These markets are usually dominated by occasional sellers. There is virtually no
administrative restriction, and sales tax is rarely charged. Due to their small size of final consumers, most fish in
these markets are bought by middlemen who then transport the fish to Jingzhou or other intermediate markets
closer to Jingzhou. On the side of fish sellers, some of them are fishermen in nearby villages who carry their catch
to the town market. The others are middlemen who bought fish from fishermen on the fishing grounds or other
intermediate markets more far away from Jingzhou and do not want to transport fish any further toward Jingzhou.

Fishing grounds serve as the wholesale spot market where middlemen compete aggressively with each other and
haggle hard with fishermen to make a good deal. There are two types of fishing grounds, corresponding to two
types of fresh water fishery. In the case of lake fishery, there are many fishermen fishing in the lake every day. rut
the catch of each fisherman is limited. A middleman usually has to buy fish from several fishermen. In the case of
pond fishery, the output of one fishpond is often too large for one middleman to handle. Yet, the information
about which pond is going to sell fish becomes highly valuable because only a few number of fishponds sell fish on
a given day.

In each fish market, when there are many sellers and buyers, the market works quite competitively. Though parties
on two sides may know each other quite well after repeated dealings with each other, personalistic trade or
clientation between trading parties is not prevalent. Not a single customer is attached to a particular seller. The
customer buys from whoever offers the best deal. Nor does a fisherman sell to a particular middleman. Whoever
has the best offer gets the deal. In most cases, the price mechanism prevails. However, this is not to say that non-
price mechanisms have no role to play. On the contrary, reputation and personal connections matter a great deal
for the success of a middleman. A sitting middleman who is viewed as dishonest can hardly survive. Similarly, a
moving middleman without a wide personal network may find it difficult to find enough fishermen from whom he
can buy fish.

These geographically separated fish markets are linked together by middlemen, whose buying and selling make the
fish market work. In this hierarchical network of fish markets, final markets in Jingzhou are where fish reach final
consumers. The price of fish at the final markets, which is determined by the supply and demand conditions, has a
strong radiating effect on all fish markets down below, which adjust their price levels accordingly after taking into
consideration the cost of transporting fish to Jingzhou. In general, the closer the market to Jingzhou, the higher the
fish price. Since there is no special institution to collect and distribute price information across markets, this job is
mainly performed by middlemen who travel up and down along the chain of markets. Yet, we can not take it for
granted that middlemen will always truthfully reveal the price information to fishermen from whom they buy fish.
Instead, the middleman is inclined to take advantage of fishermen who are poorly informed by under- reporting
the price in the city and bargaining tough in order to buy as cheap as possible. rut when more and more
middlemen visit the fishing ground, competition forces them to more candidly disclose their private price
information, and this keeps the revealed price closer to the real one in the city.

In this hierarchical network of the fish market, the role played by middlemen is quite obvious. Spatial distance
between consumers and producers makes their face-to-face transactions impossible to execute. Even when the
price that consumers are willing to pay is much higher than the price at which producers are willing to sell,
transactions may not occur and potential trade surplus can not be materialized. This physical distance is reduced,
inasmuch as middlemen travel back and forth between producers and consumers. Their buying from producers at
a price of p1 and selling to consumers at a price of p2 (p2 [greater than] p1) brings about the market for producers
and consumers, saving the cost for both to locate and meet each other. In addition to physical distance, there may
exist a time lag between the demand on the side of consumers and the supply on the side of fishermen. That is,
when the consumer has the demand for fish, the fisherman may not have fish available. Likewise, when the
fisherman wants to sell, there may be no demand on the side of consumers. The middleman coordinates the
demand and supply by storing fish when the supply exceeds the demand and releasing fish when the situation is
reversed. Lastly, the middleman is the channel of communication between the fisherman and the consumer, and
between the supply and demand of different time periods. Markets separated by geographical and temporal
distance are thus connected by middlemen.

The working of the market requires the combination of moving middlemen and sitting middlemen. Moving
middlemen buy fish from fishermen at fishing grounds, transport them to city markets, and sell them to sitting
middlemen. A moving middleman is not necessarily involved in the whole process. Indeed, the division of labor
among moving middlemen exists. Some moving middlemen are specialized in buying fish from fishermen on fishing
grounds, utilizing their knowledge of local fishermen. Usually, fish of various species and sizes are bought from
fishermen. These fish are then sorted according to their species because fish of different species and sizes are
priced differently. These sorted fish are then sold to other moving middlemen who may be specialized in trading
fish of certain species and sizes. This differentiation is partly due to the fact that different species usually need
different transportation equipment. A sitting middleman is a permanent retailer in the city market. Transactions
between sitting middlemen and consumers mark the end point of the fish flow.

This picture intuitively leads us to conceive the market as a continuum of middlemen, like a line of continuum of
points. This continuum starts with the middleman who buys from the wholesale spot market on fishing grounds,
and ends with the sitting middleman in the city market who retails fish to consumers. The middleman is specialized
and each occupies a particular point on the continuum [9] (more middlemen may be located at the same point and
competing against each other). A middleman at one point of the continuum buys from the middleman at the
preceding position, and sells to the middleman at the succeeding position. Continuous transactions between these
middlemen constitute the market. [10] rut each point on the continuum, i.e., an individual middleman or a group
of middlemen, is a "firm" if by the term we mean "a specialized unit of production" (Demsetz 1995). Every
middleman adds certain values to his input and transforms it to his output, as reflected by the fact that for each
middleman the selling price is higher than the buying price. The differentials of the market values between input
and output (which equals to the product of quantity of the fish transported and the price spread, i.e., p2 - p1) are
the added value. When it is greater than the cost associated with conducting two transactions, i.e., buying and
selling, and transportation, the firm makes a profit. Otherwise, the firm gets out of the business. When none of the
middlemen at one point of the continuum can cover operational costs, the chain of middlemen is disconnected,
and the market fails to rise.

  

 ã

"  

The single most important contribution to bring our attention to the institutional structure of the economy is
Coase's seminal article (1937), in which Coase introduces the concept of what would be later called transaction
costs to explain the emergence of the firm. The explosive literature on business firms developed over the past two
decades attests the power of Coase's simple idea.

This approach is of no less relevance to the study of the market. The market exists to reduce transaction costs and
facilitate economic transactions, when consumers and producers can freely meet each other to execute
transactions at no cost, the market as described above does not exist. In the world of zero transaction cost, as
neoclassical economics has nicely demonstrated, the market becomes a price-determining mechanism, and its
institutional setting becomes irrelevant. The ubiquitous existence of transaction costs means that the institutional
structure of exchange matters. In our case, how does the institutional structure of fish markets that we have
described in the preceding sections help to reduce transaction costs?

First of all, the emergence of the middleman-made network of fish markets is a response to the physical distance
between fishermen and fish consumers, which poses severe transaction costs for fishermen and consumers
wishing to execute transactions directly. Entrepreneurial efforts of the middlemen provide a convenient interface
for fishermen and consumers to communicate with each other and make transactions.

Next, keeping in mind the role of the institutional structure of the market in reducing transaction costs, we
examine the network structure of fish markets in some detail. Since Jingzhou is the primary consumer market, with
numerous anonymous retailers and customers trading with each other, permanent marketplaces were constructed
by the city government. In addition to the provision of shelters, the involvement of government is more clearly
indicated by the existence of the market administration office. It not only enacts a set of specific rules regulating
the behavior of retailers and customers, but also provides third-party enforcement. roth measures have
tremendously facilitated market transactions, especially from the perspective of retailers. Third-party enforcement
greatly helps retailers secure their property rights.

The market administration office also plays an important role in deterring cheating behavior on the part of
retailers, who usually have more information about their goods than consumers. Fraud on the part of retailers
usually takes the form of giving short measure or charging high price for low quality goods. Whenever a retailer is
caught defrauding, the customer can report the retailer to the market administration office. Of course it is costly
for the consumer to detect such fraud on the spot. Moreover, many attributes of a commodity can only be
detected after consumption. Spending time on searching may enable the consumer to find the lowest price in the
market. rut "searching" alone can not help the consumer detect certain qualities of the fish. Only by "experience,"
i.e., consumption, can the consumer detect whether the fish meets the quality that the retailer claims. This
renders third-party enforcement ineffective because the information that the consumer acquires ex post can not
be used as evidence for the third-party to judge whether the retailer defrauds.

A notable feature of the city market provides a remedy for this problem. In the city market, a permanent retailer
has a fixed shop place, and is thus easily identifiable. This means that reputation can work well as an informal
mechanism to check against fraud on the part of retailers. In order for reputation to work, several conditions must
be met. First of all, the game is played an infinite number of times (or it is terminated probabilistically). In repeated
transactions players' long-term interests outweigh short-term gains. Hence they restrain themselves from
opportunistic behavior in order to cultivate good reputation. In a one shot game, reputation does not matter.
Secondly, cheating behavior in one round can be easily detected before the next round of the game begins. Thus,
the cheated customer is able to punish the dishonest retailer by switching to other retailers. Thirdly, when many
individuals are involved in the game, the one with a bad reputation is easily identifiable. As a result, once detected,
the defrauding retailer can be readily recognized not only by the cheated consumer, but also by other consumers
who are informed of the bad reputation of the dishonest retailer. In the setting of a city fish market, all these
conditions are satisfied. A permanent retailer has a long-term stake in the marketplace. With a fixed shop place, he
is readily identifiable among other retailers. Although it is costly for the customer to detect frauds on the spot
when shopping in the market place, frauds can be easily discovered after the purchase. Accordingly, for a
permanent retailer, it is in his interest to maintain a good reputation and behave honestly.

Transactions in intermediate markets and on fishing grounds are fairly free from government regulation. No
special physical facilities are provided by the government, nor is any specific rule enacted or enforced. To use
North's term (1990, 34-35), transactions in these markets are a mixture of "personal exchange" and "impersonal
exchange without third-party enforcement." Nonetheless, these markets work quite well to meet the needs of
both sellers and buyers. Several factors contribute to keeping the market in place. First, in each of these
marketplaces, the number of sellers and buyers is much smaller. Market participants know each other's identities
well. Exchange transactions proceed in a much smaller scale and in a local setting. Even in these markets, however,
personalistic trading seldom occurs. Long-term contract between middlemen and fishermen is rare. In addition,
fish transactions in intermediate markets and on fishing grounds are mostly conducted in the form of wholesale.
large stakes give strong incentives to both sellers and buyers to carefully check the fish before making the deal.
Furthermore, most transactions in these markets are between fishermen and middlemen. roth groups are equally
experienced in dealing with fish. The problem of asymmetric information, if it exists at all, is not significant. In
these markets, defrauding rarely occurs on either side of the transaction.

Another notable feature of fish markets is also an efficient adjustment to the cost of transaction in the market. We
have mentioned that middlemen are differentiated into two groups, moving middlemen and sitting middlemen.
Why don't moving middlemen sell to consumers directly?

Their reluctance is attributable to the cost of entering into the city market. Transaction costs come from several
sources in the city market. First, if a moving middleman sells fish to consumers directly at the city market, he must
then pay sales tax to the administration office of the marketplace. However, the amount of the tax is not defined
by any rule, but subject to the arbitrary decision of the market administration office. This uncertainty greatly
discourages middlemen from moving into retailing, that is, selling fish to consumers. Second, without a fixed shop,
occasional sellers are viewed by consumers as less trustworthy because the mechanism of reputation does not
work. Without a long-term stake in the market, the occasional seller can not "signal" his honesty, as the
permanent seller can. Third, retailing inevitably takes a longer time than wholesaling, and requires special
investments (e.g., containers) to keep fish alive. This increases the operation cost for the moving middleman if he
engages in retailing. Fourth, the space in the fish section is rented to permanent retailers who usually do not allow
occasional sellers to sell fish around their shops. As a result, occasional sellers are usually forced out of the fish
section. All these factors push moving middlemen away from selling to consumers directly and keep them selling
fish wholesale to sitting middlemen. At the same time, the specialization of moving middlemen allows them to
know more thoroughly the marketplaces which they usually visit, and makes them well known in these
marketplaces. roth are prerequisites for their success.

To summarize, the institutional structure of the market helps reduce the cost of carrying out exchange
transactions. In local markets (i.e., intermediate markets in local towns and wholesale spot markets on fishing
grounds) where the identities of people on both sides of transactions are known, the institutional structure of
exchange is deeply embedded in and undifferentiated from the local social structure, which provides reliable
institutions and helps to lessen any uncertainty involved in transactions. In the city market, the government has a
comparative advantage in securing transactions. Indeed, the state is active in regulating market transactions, and
this state regulation immensely eases both parties in their commercial transactions.

However, the provision of the market itself is costly. At the very least, for example, some physical facilities have to
be provided. Moreover, certain rules governing exchange, such as those regarding property rights and contract,
have to be in place and enforced one way or another. The government plays an important role in reducing the cost
of providing the market. For instance, the public provision of permanent marketplaces and the existence of the
market administration office in Jingzhou greatly reduce transaction costs for both buyers and sellers. Moreover,
the general legal code is vital to protect property rights and enforce the law of contract. Actually, the market
obviously has certain features of public good because it can generate strong positive externalities once it is in
place. For example, the cost of looking for trading partners is greatly reduced. However, this is not sufficient to
justify the public provision of the market. It is true indeed that the market cannot be made and put into p lace by
the government alone. The working of the market is crucially dependent on incentives of market participants. That
is, the provision of the market requires entrepreneurial efforts. When the costs of making the market shouldered
by market participants exceed their potential gains, the market will not be provided. This point is nicely illustrated
in the following section where we compare fish marketing at two villages.
h
 

'9
 

Dong's Village (DV) and Wens Village (WV) are two fishing villages on the north side of Long Lake. The lake and its
many tributary ditches, canals, as well as ponds along the inside lake shore provide peasants at both villages with
abundant resources for freshwater fishery. The past two decades of rural reform have encouraged the steady
growth of fishery at both villages. Yet, they have developed quite different marketing channels. DV abounds with
middlemen who buy fish from fishermen on fishing grounds and transport them to intermediate fish markets or
Jingzhou. Contrarily, at WV, there are few middlemen and fishermen transport their fish across Long Lake to fish
markets themselves. In other words, fishermen at WV expand their scope of their primary activities along the
"value chain" of fishery and get involved in marketing. The forward expansion of fishing "firms" at WV contrasts
squarely with the blooming of market at DV. If the provision of the market is subject to economic analysis, this
difference suggests that the cost of establishing the market is so high at WV that the market fails to emerge. What
makes the cost of establishing the market so different between DV and WV?

With this question in mind, we take a brief look at the two villages. roth DV and WV are on the north side of Long
Lake. They are separated from each other by Wang's ray, an inlet of Long Lake. Wang's ray is the county
borderline between Jiangling and Jingmen. DV is on the west side of the bay and belongs to Jiangling county; WV is
on the east side and belongs to Jingmen county. Since final fish markets are located in Jingzhou, fish in both
villages have to be transported across Long Lake and carried to Jingzhou one way or another. Long Lake has three
ports for passengers traveling across the lake. Port A is on the south side shore. Ports r and C are on the north
side. Port r is in DV; Port C in WV. Port A is 20 minutes away from Jingzhou by bus, and there is convenient public
transportation between Port A and the city. Close to the highway linking Jingzhou and Wuhan, the capital city of
Hubei Province, Port A has the most important intermediate fish market in this area.

Comparing the two routes of fish transportation at DV and WV, we realize that the distance between Ports A and r
is much shorter than the one between Ports A and C. This factor gives rise to the considerable difference of
transportation costs, which turns out to be crucial in determining the difference of marketing channels between
these two villages.

Water transportation across Long Lake is mainly by passenger ship. There are two transportation routes across the
lake, the one between Ports A and r, and the other one between Ports A and C. The distance of the first route is
about three kilometers and it takes 15 minutes; while the distance of the second one is 15 kilometers and it takes a
little more than one hour. Moreover, the passenger ship of the first route travels more frequently. In a normal day,
the ship travels back and forth between Ports A and r for as many as 20 times, from six in the early morning until
later afternoon. Contrarily, the ship on the second route usually travels four times a day. The much shorter
physical distance between Ports A and r is certainly an important factor. Moreover, since DV is in jiangling county,
compared with WV, it has more intensive connections with Jingzhou and other towns on the south side of the lake
which also belong to the same county. For example, a lot of villagers from DV work in Jingzhou. Peasants in DV
have relatives on the south side of the lake. In addition, intensive interactions between DV and Jingzhou and busy
schedules between Ports A and r reinforce each other: more interactions demand more frequent shipping
schedules; frequent schedules make interactions more convenient between the two sides of the lake. In a similar
way, scant interactions between WV and the south side of the lake require fewer schedules between Ports A and
C, which in turn discourage intensive interactions to develop. As a result, longer distance and much fewer
schedules between Ports A and C make transportation between Ports A and C much more difficult. This
considerably increases the transportation cost that the middleman has to incur if he buys fish from WV.
Moreover, as far as fish transportation is concerned, there is another factor working against the fishermen at WV.
In the process of fish transportation, caution must be taken to keep fish alive. This factor makes a huge difference
in terms of how fish are transported. The average time of transporting fish from DV to Port A is about 15 minutes.
Within this period of time, no special equipment is needed to keep fish alive. Middlemen most often simply use a
pair of bamboo baskets to carry fish from DV. On the other hand, the average time of transporting fish from WV to
Port A is more than an hour. For such a long period of time, the middleman has to use large containers, such as
wooden buckets, to keep fish alive.

High transportation costs make WV less attractive to middlemen, but this does not necessarily prohibit them from
going there. If a middleman is able to buy fish at a sufficiently low price at WV so that high transportation costs can
be compensated, there is no reason for him not to visit WV. Yet this scenario does not unfold. On the contrary,
when the number of middlemen visiting WV is limited, bargaining between them and fishermen becomes hostile
and readily breaks up, long before reaching a good deal.

The failure of bargaining between middlemen and fishermen at WV is mainly caused by the problem of private
information. As we know, price information in the network of fish markets is primarily distributed by moving
middlemen, who travel between the city and local towns as well as fishing grounds. When there are few
middlemen competing with each other, the middleman is more likely to over-report the cost of transportation and
under-report the fish price in the city; in addition he will probably over-report costs and under-report the price
even more than usual, all to seek a larger share of gains from transactions with fishermen. With few middlemen to
choose from, the fishermen become highly skeptical of the price information communicated by the middlemen,
and they tend to bargain cautiously to avoid being cheated. These two conflicting tendencies are inclined to tear
bargaining apart.

A numeric example may help to illustrate the point. Suppose the fisherman values his fish at a price of $4. The
middleman reports that the price at Jingzhou is $10. Then, there is a wide range of prices ($4, $10) for them to
bargain. For simplicity, suppose both parties expect to equally divide the surplus of trade (which is $10 - $4 M $6),
then the outcome is a price of $7 ($4 + 1/2 * $6 M $7). Now, let us take into consideration the problem of
information. When there are only a couple of middlemen traveling to WV, the price information revealed by them
becomes suspicious to fishermen. Suppose the price in Jingzhou has two states of equal possibility, either a high
price of $12 or a low one of $8. This is common knowledge for both the fisherman and the middleman. rut the
fisherman does not know what the price is on any particular day. If the price information could be credibly
communicated between the middleman and fisherman, they would reach a deal at $8 or $6. However, when the
number of middlemen visiting WV is quite limited, so the middleman tends to under-report the price, and keep a
larger slice of the trade surplus. This strong incentive on the part of middleman to under-report the price makes
the fisherman suspicious about the price information communicated by the middleman. Even when the
middleman truthfully reveals the price information, the fisherman does not take it at face value simply because he
has no way to check whether the middleman is honest. As a result, even when the middleman is honest, it does
not increase his chance of making a deal with the fisherman. As for the middleman, he does not have any means to
persuade to the fisherman that he is honest. For example, if the middleman honestly reports that the price is $8,
the fisherman is prone to think that the he is under-reporting the price. While the middleman expects a price of $6
as the deal, the fisherman anticipates a price of $8, a price that the middleman can not possibly offer. As a result,
bargaining between the middleman and fisher man tends to fail. Overall, bargaining between the middleman and
fisherman tends to break up about half of the time when we assume the price has two states of equal likelihood.
Since fish prices vary continuously in the real world, bargaining becomes extremely difficult when the fisherman is
skeptical of the middleman's price information.
In addition to the problem of bargaining, high transportation cost of carrying fish across the lake from WV to Port A
makes WV less attractive to middlemen. Indeed, the middleman takes bigger risk when he buys fish from
fishermen at WV: it takes longer to transport fish from WV to Jingzhou and thus creates uncertainty because fish
are more likely to die in long distance transportation and the fish price fluctuates. Hence, the middleman must
take the factor of risk premium into consideration, in addition to the increased transportation cost, when
bargaining with fishermen at WV. Therefore the middleman bargains tough with fishermen at WV to push the
price down. When the likelihood of stalemate or bargaining failure increases, the risk premium increases
accordingly, and bargaining becomes more aggressive and hence more likely to fail.

To put it in a nutshell, the high cost of transactions between middlemen and fishermen at WV reduces the number
of middlemen visiting WV, and increases the risk involved in buying fish there. These two mechanisms reinforce
each other to make bargaining more difficult between fishermen and middlemen. On the one hand, as fewer
middlemen go to WV, price information is less likely to be credibly transmitted to fishermen; as information
asymmetry worsens between fishermen and the middleman, bargaining between them is more likely to fail. At the
same time, the high probability of bargaining failure increases the risk premium that the middleman takes into
account during price bargaining with the fishermen. This makes middlemen more aggressive in bargaining, and
once again the bargaining is more likely to break down. In turn, the bleak chance of successful bargaining
discourages middleman from traveling to WV. With fewer and fewer middlemen going to WV, the bargaining
becomes even more difficult and more likely to f all into an impasse. This self-perpetuating cycle blocks middlemen
from visiting WV. Hence a price mechanism cannot be established and the market fails to emerge. As a result,
fishermen at WV transport their fish across Long Lake to the market directly.

From the perspective of the fisherman at WV, the vertical integration of transportation into the value chain is
apparently an expansion of the scope of the "firm." At WV, the division of labor between' fishing and fish
transportation does not exist. roth activities are performed within one firm. This is sharply different from the case
at DV, where fishing and fish transportation are undertaken by separate specialized firms, with the market
coordinating transactions between the fishing firm (i.e., fishermen) and the transportation firm (that is,
middlemen). From the standpoint of the fisherman at DV, fish transportation is undertaken through the market,
not within the "firm."

The market and the firm are two alternatives for conducting fish transportation. At WV, the firm (that is, the
fisherman) expands and integrates fish transportation into its scope of activities or value chain. At DV, there is a
division of labor between fishing and fish transportation and the fisherman turns to the market for fish
transportation. This contrast is consistent with the basic logic embodied in Coase's (1937) classic article, which says
that the firm expands and supersedes the market when the cost of using the price mechanism is high. However the
situation differs from Coase's theory, which starts with a world of pure market transactions, in that the market
does not even exist at WV simply because it is too costly to be set up.

At DV, low transaction costs incurred to middlemen make their entrepreneurial efforts rewarding. When they stay
in business, the market is thus at work. The market itself consists of a chain of middlemen, each of whom qualifies
as a firm, buying and selling, calculating profit and the cost of making profit. The existence of the market
encourages the division of labor between fishing and fish transportation, and hence increases specialization.
Viewed this way, the market and the firm are not substitutes for each other; instead, they are complements.

Though each middleman is viewed as a firm, it is a special type of firm whose function is to create a market
between producers (e.g., fishermen) and consumers (e.g., city residents). The market is thus dependent on the
entrepreneurial efforts of middlemen. Apparently then, its existence can not be taken for granted. Indeed, there
were simply no markets in the beginning when commercial activities were criminalized by the law under the
doctrine of socialist planned economy. The market comes into place when the middleman is able to profit from
buying and selling. Comparing the different marketing channels at DV and WV nicely illustrates the point that the
provision of the market is costly and requires entrepreneurial efforts. When the cost of providing the market at
WV is too high, the market fails to emerge. The difference between the institutional structure of exchange in the
fishery industry at DV and WV brings us back to the central point in new institutional economics, that transaction
cost is a primary determinant of the institutional structure of the economy (Coase 1992).

 

 

Ever since Adam Smith, the development of the division of labor and the market has been viewed as a natural
consequence of human propensity, "the propensity to truck, barter, and exchange." Neither the actual operation
of the market system nor the evolution of the institutional structure of the market has seriously interested
economists who claim to study the working of the market. Staying aloof from the real world market not only
makes economists blind to the cost of using the market system, but also makes them inclined to take the market
as given and assume that "in the beginning there were markets" (Fourie 1993). This study shows however that the
market did not exist in the beginning. Instead, the provision of the market involves entrepreneurial endeavors and
is subject to cost-benefit analysis. When the cost of providing the market exceeds the potential gains, the market
will not be provided at all.

Focusing on the operation of fish markets in a Chinese fishery community, this case study brings some realism into
economic analysis. In the process of examining how this fish market works, this case study empirically
demonstrates that the institutional structure of exchange responds to the cost of carrying out exchange
transactions. The differing cost of organizing fish transportation at DV and WV gives rise to the stark difference in
the institutional structure of fish transportation at these two villages. From the perspective of fishermen, fish
transportation at DV is left to the market; at WV it is performed within the "firm."

In this study, the market consists of a continuum of middlemen, whose entrepreneurial efforts of buying and
selling bring the market to work. The raison d'etre for middlemen is to reduce transaction cost for both fishermen
and consumers. This is consistent with the Coasean view of the market: "Markets are institutions that exist to
facilitate exchange, that is, they exist in order to reduce the cost of carrying out exchange transactions." (Coase
1988a, 7). Unlike most studies which assume "in the beginning there were markets," this study takes one step
further to demonstrate that the provision of the market depends on whether the middleman can make a profit
and stay in business. ry doing so, this paper sheds new light on the relationship between the firm and the market
vis-a-vis transaction costs.

ã
: The American Journal of Economics and Sociology, Oct, 1999, by Ning Wang


 

1. Do you really think that the institutional structure of exchange responds to the cost of carrying out
exchange transactions? Explain.
2. Which factors bring market to work?
3. ͞The provision of the market depends on whether the middleman can make a profit and stay in business͟,
do you agree with this statement?
 c
4

"hh"¢*¢  ¢!"ã#";

The most important role of the capital market is allocation of possession of the economy͛s capital stock.
In general terms, the ideal is a market in which prices provide correct signals for resource allocation:
that is, a market in which firms can make production-investment decisions, and investors can choose
among the securities that symbolize possession of firm͛s activities under the assumption that security
prices at any time ͞fully reflect͟ all available information. A market in which prices always ͞fully reflect͟
accessible information is known as ͞efficient͟.
The purpose of capital markets is to transfer funds between lenders (savers) and borrowers (producers)
efficiently. Individuals or firms may have access the market-determined borrowing rate but not enough
funds to take advantage of all these opportunities. Nevertheless, if capital markets exist, they can
borrow the needed funds. Lenders, who have excess funds after exhausting all their productive
opportunities with expected returns greater than the borrowing rate, will be willing to lend their excess
funds for the reason that the borrowing/lending rate is higher than what they might otherwise earn.
Hence both borrowers and lenders are better off if efficient capital markets are used to facilitate fund
transfers. The borrowing/lending rate is used as a significant piece of information by each producer,
who will accept projects until the rate of return on the least profitable project just equals the
opportunity cost of external funds (the borrowing/lending rate).
Expected Return or ³Fair Game´ Models
The definitional statement that in an efficient market prices ͞fully reflect͟ accessible information is so
wide-ranging that it has no pragmatically testable entailments. To make the model testable, the process
of price formation must be specified in more detail. In essence we must define somewhat more exactly
what is intended by the term ͞fully reflect.͟
One option would be to hypothesize that equilibrium prices (or expected returns) on securities are
generated as in the ͞two parameter͟ Sharpe and Linter world. In general, nevertheless, the theoretical
models and especially the empirical tests of capital market efficiency have not been this specific. Most
of the available work is based only on the assumption that the conditions of market equilibrium can
(somehow) be stated in terms of expected returns. In common terms, like the two parameter model
such theories would hypothesize that conditional on some relevant information set, the equilibrium
expected return on a security is a function of its ͞risk.͟ And different theories would differ primarily in
how ͞risk͟ is defined.
All members of the class of such ͞expected return theories͟ can, nevertheless, be described notationally
as follows:
 Ë 
|    |
Ë 
|     (1)
where E is the expected value operator; pjt is the price of security j at time t; pj,t+1 is its price at t+1 (with
reinvestment of any intermediate cash income from the security); rj,t+1 is the one-period percentage
return (pj,t+1 ʹ pjt)/pjt; ʔt is a general symbol for whatever set of information is assumed to be ͞fully
reflected͟ in the price at t; and the tildes indicate that pj,t+1 and rj,t+1 are random variables at t.
The value of the equilibrium expected return  Ë 
|   projected on the basis of the information ʔt
would be determined from the particular expected return theory at hand. The conditional expectation
notation of (1) is meant to imply, nevertheless, that whatever expected return model is assumed to
apply, the information in ʔt is fully utilized in determining equilibrium expected returns. And this is the
sense in which ʔt is ͞fully reflected͟ in the formation of the price pjt.
rut we should note right off that, simple as it is, the assumption that the conditions of market
equilibrium can be stated in terms of expected returns elevates the purely mathematical concept of
expected value to a status not necessarily implied by the general notion of market efficiency. The
expected value is just one of many possible summary measures of a distribution of returns, and market
efficiency per se (i.e., the general notion that prices ͞fully reflect͟ available information) does not imbue
it with any special significance. Thus, the results of tests based on this assumption depend to some
extent on its validity as well as on the efficiency of the market. rut some such assumption is the
unavoidable price must pay to give the theory of efficient markets empirical content.
The assumptions that the conditions of market equilibrium can be stated in terms of expected returns
and that equilibrium expected return are formed on the basis of (and thus ͞fully reflect͟) the
information set ʔt have a major empirical implicationͶthey rule out the possibility of trading systems
based only on information in ʔt that have expected profits or returns in excess of equilibrium expected
profits or returns. Thus let
   È|


   È|
    È|   (2)
Then,
Ë!|     (3)
which, by definition, says that the sequence {Xjt} us a ͞fair game͟ with respect to the information
sequence {ʔt}. Or, equivalently, let
" | | #$Ë 
 | %  (4)
then
$" | %  ()
so that the sequence {zjt} is also a ͞fair game͟ with respect to the information sequence {ʔ}.
In economic terms, xj,t+1 is the excess market value of security j at time t+1: it is the difference between
the observed price and the expected value of the price that was projected at t on the basis of the
information ʔt. And similarly, zj,t+1 is the return at t+1 in excess of the equilibrium expected return
projected at t. Let

   
|   
  
   
be any trading system based on ʔt which tells the investor the amounts ɲj(ʔt) of funds available at t that
are to be invested in each of the n available securities. The total excess market value at t+1 that will be
generated by such a system is

| Þ   %  | &$
| %  
 |

which, from the ͞fair game͟ property of (5) has expectation,

Ë
'!|   Þ (    "Ë!|  
|
The expected return or ͞fair game͟ efficient markets model has other significant testable implication,
but these are better saved for the later discussion of the empirical work. Now we turn to two special
cases of the model, the submartingale and the random walk, that (as we shall see later) play an
significant role in the empirical literature.
 ã$

 
Suppose we assume in (1) that for all t and ʔt.
$ | %  Ô  , or equivalently, $
| % ) . (6)
This is a statement that the price sequence {pjt} for security j follows a submartingale with respect to the
information sequence {ʔt}, which is to say nothing more than that the expected value of next period͛s
price, as projected on the basis of the information ʔt, is equal to or greater than the current price. If (6)
holds and equality (so that expected returns and price changes are zero), then the price sequence
follows a martingale.
A submartingale in prices has one significant empirical implication. Consider the set of ͞one security and
cash͟ mechanical trading rules by which we mean systems that concentrate on individual securities and
that define the conditions under which the investor would hold a given security, sell it short, or simply
hold cash at any time t. Then the assumption of (6) that expected returns conditional on ʔt are non-
negative directly implies that such trading rules based only on the information in ʔt cannot have greater
expected profits than a policy of always buying-and-holding the security during the future period in
question. Tests of such rules will be an significant part of the empirical evidence on the efficient markets
model.
  : 
In the early treatments of the efficient markets model, the statement that the current price of a security
͞fully reflects͟ available information was assumed to imply that successive price changes (or more
generally, successive one-period returns) are independent. In addition, it was generally assumed that
successive changes (or returns) are identically distributed. Together the two hypotheses constitute the
random walk model. Formally, the model says
|    |  (7)
which is the usual statement that the conditional and marginal probability distributions of an
independent random variable are identical. In addition, the density function f must be the same for all t.
Expression (7) of course says much more than the general expected return model summarized by (1).
For example, if we restrict (1) by assuming that the expected return on security j is constant over time,
then we have
$ 
| %  $|  (8)
This says that the mean of the distribution of rj,t+1 is independent of the information available at t, ʔt,
whereas the random walk model of (7) in addition says that the entire distribution is independent of ʔt.
We argue later that it is best to regard the random walk model as an extension of the general expected
return or ͞fair game͟ efficient markets model in the sense of making a more detailed statement about
the economic environment. The ͞fair game͟ model just says that the conditions of market equilibrium
can be stated in terms of expected returns, and thus it says little about the details of the stochastic
process generating returns. A random walk arises within the context of such a model when the
environment is (fortuitously) such that the evolution of investor tastes and the process generating new
information combine to produce equilibria in which return distributions repeat themselves through
time.
Thus it is not surprising that empirical tests of the ͞random walk͟ model that are in fact tests of ͞fair
game͟ properties are more strongly in support of the model than tests of the additional (and, from the
viewpoint of expected return market efficiency, superfluous) pure independence assumption. (rut it is
perhaps equally surprising that, as we shall soon see, the evidence against the independence of returns
over time is as weak as it is).

 

 
 '
 "

 
refore turning to the empirical work, nevertheless, a few words about the market conditions that might
help or hinder efficient adjustment of prices to informations are in order. First, it is easy to determine
sufficient conditions for capital market efficiency. For example, consider a market in which (i) there are
no transactions costs in trading securities, (ii) all available information is costlessly available to all market
participants, and (iii) all agree on the implications of current information for the current price and
distributions of future prices of each security. In such a market, the current price of a security obviously
͞fully reflects͟ all available information.
rut a frictionless market in which all information is freely available and investors agree on its
implications is, of course, not descriptive of markets met in practice. Fortunately, these conditions are
sufficient for market efficiency, but not necessary. For example, as long as transactors take account of all
available information, even large transactions costs that inhibit the flow of transactions do not in
themselves imply that when transactions do take place, prices will not ͞fully reflect͟ available
information. Similarly (and speaking, as above, somewhat loosely), the market may be efficient if
͞sufficient numbers͟ of investors have ready access to available information. And disagreement among
investors about the implications of given information does not in itself imply market inefficiency unless
there are investors who can consistently make better evaluations of available information than are
implicit in market prices.
rut though transactions costs, information that is not freely available to all investors, and disagreement
among investors about the implications of given information are not necessarily sources of market
inefficiency, they are potential sources. And all three exist to some extent in real world markets.
Measuring their effects on the process of price formation is, of course, the major goal of empirical work
in this area.
All the empirical research on the theory of efficient markets has been concerned with whether prices
͞fully reflect͟ particular subsets of available of available information. Historically, the empirical work
evolved more or less as follows. The initial studies were concerned with what we call weak form tests in
which the information subset of interest is just past price (or return) histories. Most of the results here
come from the random walk literature. When extensive tests seemed to support the efficiency
hypothesis at this level, attention was turned to semi-strong form tests in which the concern is the
speed of price adjustment to other obviously publicly available information (e.g., announcements of
stock splits, annual reports, new security issues, etc.). Finally, strong form tests in which the concern is
whether any investor or groups (e.g., managements of mutual funds) have monopolistic access to any
information relevant for the formation of prices have recently appeared. We review the empirical
research in more or less this historical sequence.
First, nevertheless, we should note that what we have called the efficient markets model in the
discussions of earlier sections is the hypothesis that security prices at any point in time ͞fully reflect͟ all
available information. Though we shall argue that the model stands up rather well to the data, it is
obviously an extreme null hypothesis. And, like any other extreme null hypothesis, we do not expect it
to be literally true. The categorization of the tests into weak, semi-strong, and strong form will serve the
useful purpose of allowing us to pinpoint the level of information at which the hypothesis breaks down.
An we shall contend that there is no significant evidence against the hypothesis in the weak and semi-
strong form tests (i.e., prices seem to efficiently adjust to obviously publicly available information), and
only limited evidence against the hypothesis in the strong form tests (i.e., monopolistic access to
information about prices does not seem to be a prevalent phenomenon in the investment community).
Ä


   


 

 

As noted earlier, all of the empirical work on efficient markets can be considered within the context of
the general expected return or ͞fair game͟ model, and much of the evidence bears directly on the
special submartingale expected return model of (6). Indeed, in the early literature, discussions of the
efficient markets model were phrased in terms of the even more special random walk model, though we
shall argue that most of the early authors were in fact concerned with more general versions of the ͞fair
game͟ model.
Some of the confusion in the early random walk writings is understandable. Research on security prices
did not begin with the development of a theory of price formation which was then subjected to
empirical tests. Rather, the impetus for the development of a theory came from the accumulation of
evidence in the middle 1950͛s and early 1960͛s that the behavior of common stock and other
speculative prices could be well approximated by a random walk. Faced with the evidence, economists
felt compelled to offer some rationalization. What resulted was a theory of efficient markets stated in
terms of random walks, but generally implying some more general ͞fair game͟ model.
It was not until the work of Samuelson and Mandelbrot in 1965 and 1966 that the role of ͞fair game͟
expected return models in the theory of efficient markets and the relationships between these models
and the theory of random walks were rigorously studied. As these papers came somewhat after the
major empirical work on random walks. In the earlier work, ͞theoretical͟ discussions, though generally
intuitively appealing, were always lacking in rigor and often either vague or ad hoc. In short, until the
Mandelbrot-Samuelson models appeared, there existed a large body of empirical results in search of a
rigorous theory.
Thus, though his contributions were ignored for sixty years, the first statement and test of the random
walk model was that of rachelier in 1900. rut his ͞fundamental principle͟ for the behavior of prices was
that speculation should be a ͞fair game͟; in particular, the expected profits to the speculator should be
zero. With the benefit of the modern theory of stochastic processes, we know now that the process
implied by this fundamental principle is a martingale.
After rachelier, research on the behaviour of security prices lagged until the coming of the computer. In
1953 Kendall examined the behavior of weekly changes in nineteen indices of rritish industrial share
prices and in spot prices of cotton (New York) and wheat (Chicago). After extensive analysis of serial
correlations, he suggests, in quite graphic terms:
 
 


   
  

 
      
  

 
 
   




 




    !


 
 
 



 

 



 

! 

"

#
Kendall͛s conclusion had in fact been suggested earlier by Working though his suggestion lacked the
force provided by Kendall͛s empirical results. And the implications of the conclusion for stock market
research and financial analysis were later underlined by Roberts.
rut the suggestion by Kendall, Working, and Roberts that series of speculative prices may be well
described by random walks was based on observation. None of these authors attempted to provide
much economic rationale for the hypothesis, and, indeed, Kendall felt that economists would usually
reject it. Osborne suggested market conditions, similar to those assumed by rachilier, that would lead to
a random walk. rut in his model, independence of successive price changes derives from the assumption
that the decisions of investors in an individual security are independent from transaction to transactionʹ
which is little in the way of an economic model.
Whenever economists (prior to Mandelbrot and Samuelson) tried to provide economic justification for
the random walk, their arguments generally implied a ͞fair game.͟ For example, Alexander states:
O  
  

   




    

 


  


# 





   


 
 


#
!
 
 

   
 





    
   
!
     

"


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#
O
  
 


    


  
  

 



  # 
 


   

  
!
    
     
  



 


  

 


   

 

  
   


   
 

#
Although to some extent vague, the last sentence of the first paragraph seems to point to a ͞fair
game͟ model rather than a random walk. In this light, the second paragraph can be viewed as an
attempt to explain environmental conditions that would reduce a ͞fair game͟ to a random walk.
rut the specification imposed on the information generating process is inadequate for this
purpose; one would, for instance, also have to say something about investor tastes.
ry distinction, the stock market trader has a much more practical criterion for judging what
constitutes significant dependence in successive price changes. For his purpose the random walk
model is valid as long as knowledge of the past behavior of the series of price changes cannot be
used to increase expected gains. More particularly, the independence assumption is an
sufficient description of reality as long as the actual degree of dependence in the series of price
changes is not enough to allow the past history of the series to be used to predict the future in a
way which makes expected profits greater than they would be under a naïve buy and hold
model.
We know now, of course, that this last condition hardly needs a random walk. It will in fact be
met by the submartingale model.
rut one should not be too hard on the hypothetical efforts of the early empirical random walk
literature. The arguments were generally appealing; where they fell short was in consciousness
of developments in the theory of stochastic processes. Furthermore, we shall now see that most
of the experiential evidence in the random walk literature can easily be interpreted as tests of
more common expected return or ͞fair game͟ models.
   
"

 
  :



As discussed earlier, ͞fair game͟ models entail the ͞impossibility͟ of different sorts of trading
systems. Some of the random walk literature has been concerned with testing the profitability
of such systems. More of the literature has, nevertheless, been concerned with tests of serial
covariances of a ͞fair game͟ are zero, so that these tests are also relevant for the expected
return models.
If xt is a ͞fair game,͟ its unconditional expectation is zero and its serial covariance can be written
in general form as:
Ë! Ë  ø   Ë!      


where f indicates a density function. rut is xt is a ͞fair game,͟

Ë!    X
From this it follows that for all lags, the serial covariances between lagged values of a ͞fair
game͟ variable are zero. Thus, observations of a ͞fair game͟ variable are linearly independent.
rut the ͞fair game͟ model does not necessarily imply that the serial covariances of one-period
returns are zero. In the weak form tests of this model the ͞fair game͟ variable is
"    & Ë
&| &
  (9)
rut the covariance between, for example, rjt and rj,t+1 is
Ë Ë Ë Ë
!| # !|  # 

M ø 

 &  
  !|  & !|     

and (9) does not imply that Ë Ë

!|   M !|  : In the ͞fair game͟ efficient markets model, the

deviation of the return for t+1 from its conditional expectation is a ͞fair game͟ variable, but
conditional expectation itself can depend on the return observed for t.
In the random walk literature, this problem is not documented, from the time when it is
assumed that the predictable return (and indeed the entire distribution of returns) is stationary
through time. In practice, this implies estimating serial covariances by taking cross products of
deviations of experiential returns from the overall sample mean return. It is rather accidental,
then, that is procedure, which represents a rather gross estimate from the point of view of the
wide-ranging expected return efficient markets model, does not seem to very much influence
the results of the covariance tests, at least for common stocks.
h ¢ "hh#"9¢ c"hh ¢
The notion of efficient capital markets depends on the precise definition of information and the
value of information obtained from it. An information structure may be defined as a message
about various events that may happen. For instance, the message ͞there are no clouds in the
sky͟ provides a probability distribution for the likelihood of rain within the next 24 hours. This
message may have various values to different people depending on (1) whether or not they can
take any actions based on the message and (2) what net benefits will result from their actions.
For example, a message related to rainfall can be of value to farmers, who can act on the
information to increase their agricultural products. If there is no rain, the farmers might decide
that it would be a good time to harvest hay. On the other hand, messages about rainfall have no
value to deep-pit coal miners for the reason that such information probably will not alter the
miners͛ actions at all.
A formal expression of the above concept defines the value of an information structure as
   Þ * +, Þ -.#
  (10)
 

where,
() M the prior probability of receiving a message ;
(
|) M the conditional probability of an event
, given a message ;

(,
) M the utility resulting from an action  if an event
occurs (

   )
$(%0) M the expected utility of the decision maker without the information.
According to Eq. (10), a decision maker will evaluate an information structure (which, for the
sake of generality, is defined as a set of messages) by choosing an action that will maximize his
or her expected utility, given the arrival of the message. For example, if we receive a message
(one of many that we could have received) that there is a 20% chance of rain, we may carry an
umbrella for the reason that of the high ͞disutility͟ of getting drenched and the low cost of
carrying it. For each possible message we can determine our optimal action. Mathematically,
this is the solution to the problem
* ,Þ   -  c   



Finally, by weighting the expected utility of each optimal action (in response to all possible
messages) by the probability, (), of receiving the message that gives rise to the action, the
decision maker knows the expected utility of the entire set of messages, which we call the
expected utility (or utility) or utility value of an information set, (%).
Note that the value of information as defined above in Eq. (10) in a one period setting is very
close to the value of a real option in a multi-period setting. The basic idea is the same. Given the
arrival of information a decision maker is assumed to have the right, but not the obligation, to
take and action. For this reason, the value of information is optimized along three variables,
namely, the payoff to the decision maker, the information about the event given the message,
and the action assumed to be taken by the decision maker.
To illustrate the value of information, consider the following example. The analysis division of a
large retail brokerage firm hires and trains analysts to cover events in various regions around
the world. The CIO (Chief Information Officer) has to manage the allocation of analysts and deal
with the fact that the demand for analyst coverage is uncertain. To keep it simple, suppose we
need 300 analysts or 0 analysts with 50-50 probability for coverage in each of three countries.
The CIO is considering three possibilities.
Policy 1: Hire analysts and keep them on their initial allocations.
Policy 2: Switch analysts at a cost of 20 thousand dollars when it makes sense.
Policy 3: Create a catalogue (CAT) that provides better information (e.g., their language
capabilities, their technical skills, etc.) for matching analysts to countries when they are
switched.
The CIO has assigned project weights to various allocation results:
 :
  (

 M c( ))
Analyst skilled in a job 100 units
Analysts unsatisfactory in job 30 units
Shortage ʹ no one in job 0 units
Excess ʹ no demand for job ʹ 30 units

$40¢*

 r
 

 
:
 ¢ :
 ¢
Probability of being skilled on the job .7 1.0
Probability of being mismatched .3 0.0

We would like to know which is the best policy, what it implies about the number of analysts to hire
initially, and what value should be given to the CAT information. The intuition is reasonably clear. If, for
example, the CAT information does not help much to make better job allocations, if the cost of
mismatch is relatively low, or if the cost of switching is close to zero, then the value differential between
policies 1 and 2 will be low. Table 2.1 shows the probability of getting the right analyst into the right job
without having the catalogue information (right-hand side).Assuming that analysts are allocated without
the benefit of CAT, there is 70% chance of allocating the analyst with the right skills to the right job.
Nevertheless, if the CAT information is available, the probability of a correct allocation goes up to 100
percent.
If the brokerage company adopts a policy of not retraining and reallocating analysts, it should hire 900
analysts for a value of 20,050. This result follows from the fact that there are four states of nature, with
demand of 0, 300, 600, and 900 analysts, respectively.
To determine the expected payout from a policy of hiring 600 analysts, but not reallocating them, we
can refer to table 2.2. With 600 analysts we would allocate 200 to each of the countries (A, r, and C). If
demand turns out to be 300 in total, the country that has that demand will be 100 analysts short and
there will be no reallocation. The payout for 140 of the analysts who turn out to be skilled on the job is
100, and the payout for 60 analysts who are unsatisfactory is 30 each. The shortage of 100 has no cost
or benefit and there is no excess. Hence, the probability-weighted payment is
.375{[140(100) + 60(30)] + 400(ʹ30)} M 1,425.
Table 2.2: Expected Payout from Hiring 600 Analysts and Not Reallocating Them
 >ã
  *
$$

  
  
  

¢ r 
0 .125 0/200 0/200 0/200
300 .375 300/200 0/200 0/200
600 .375 300/200 300/200 0/200
900 .125 300/200 300/200 300/200
  

  ã

  ã 
 "   

$
 
0 0 0 0(0) 600(ʹ30) ʹ2,250
300 (.7)(200)(100) (.3)(200)(30) 100(0) 400(ʹ30) 1,425
600 (.7)(400)(100) 2(.3)(400)(30) 200(0) 200(ʹ30) 9,600
900 (.7)(600)(100) (.3)(600)(30) 100(0) 0 5,925
14,700
Next, if demand turns out to be 600, it would reach that level for the reason that two of the three
countries have demand of 300. Each would have been allocated 200 and would have a 100-person
shortage. The third country would have an excess of 200. The probability-weighted outcome is
.375{[2[140(100) + 60(30)] + 200(ʹ30) + 0}} M 9,600.
To complete the analysis of a strategy that consists of hiring 600 people and not reallocating them, we
go the last column in table 2.2, where the probability-weighted contributions add to 14,700.
The results for all strategies are given in Table 2.3. The value maximizing strategy without reallocation is
to hire 900 people, enough to supply maximum demand for analysts in all three countries. rut with the
human resources catalogue (CAT) that makes the process of reallocation more accurate, the value-
maximizing policy is to hire 600 people with the expectation that many would be reallocated. The
difference between the value of reallocation without CAT and reallocation with it is the value of having
the CAT (i.e., 28,825 ʹ 22,462).
$406  
¢ã

 
¢

  

Number No Reallocation Reallocation
Hired Reallocation without CAT with CAT
0 0 0 0
300 7,350 16,328 20,625
600 14,700 22,462 28,875
900 22,050 22,050 28,125
1,200 13,050 13,050 19,125
" ¢ã#*r":""#"9¢ c"hh ¢¢"hh"¢*¢  ¢!"ã
The equation 10 above can be used to evaluate any information structure. It also points out some ideas
that are implicit in the definition of efficient markers. Fama (1976, 1991) defines efficient capital
markets as those where the joint distribution of security prices at a period, given the set of information
that the market uses to determine security prices, is identical to the joint distribution of prices that
would exist if all relevant information available at that period were used. This implies that there must be
no distinction between the information the market uses and the set of all relevant information. Applying
information theory, this also implies that net of costs, the utility value of the gain from information to an
individual in nil.
For instance, the Nigerian Stock Exchange (NSE) has been described as being efficient in the weak form.
The relevant information structure, ni, is defined to be the set of historical prices on all assets. Hence,
the distribution of security prices today has already incorporated past price histories. For this reason, it
is not possible to develop trading rules (courses of action) based on past prices that will allow anyone to
͚outperform͛ the market. In other words, the value of the gain from information to an ith individual,
must be zero.
 $(ɻi) ʹ $(%0) M 0 (11)
Equation (11) says that no one would pay anything for the information set of historical prices. It is
pertinent to note that the capital market is efficient relative to a given information set only after
consideration of the costs of acquiring messages and taking actions pursuant to a particular information
structure.
¢!""hh";¢¢¢ "?*"¢ã
Our aim is to have an insight into how the marginal investor͛s decision-making process, given the receipt
of information, is reflected in the market prices of assets. Nevertheless, it is difficult to observe the
quantity and quality of information or the timing of its receipt in the real world. Even the issue of what
information is relevant to investors has been an unresolved matter amongst theorists. Forsythe, Palfrey,
and Plott (1982) identify four different hypotheses. Each hypothesis assumes that investors know with
certainty what their own payoffs will be across time, but they also know that different individuals may
pay different prices for the reason that of differing preferences.
The first hypothesis, known as naïve hypothesis, asserts that asset prices are completely arbitrary and
unrelated either to how much they pay out in the future or to the probabilities of various payouts. The
second hypothesis, known as the speculative equilibrium hypothesis, implies that all investors base their
investment decisions entirely on their anticipation of other individual͛s behaviour without any necessary
relationship to the actual payoffs that the assets are expected to provide. The third hypothesis is that
asset prices are systematically related to their future payouts. Called the intrinsic value hypothesis, it
says that prices will be determined by each individual͛s estimate of the payoffs of an asset without
consideration of its resale value to other individuals. The fourth hypothesis may be called the rational
expectations hypothesis. It predicts that prices are formed on the basis of the expected future payouts
of the assets, including their resale value to third parties. Thus, a rational expectations market is an
efficient market for the reason that prices will reflect all information. In the rational expectations model,
differential payoffs indicate heterogeneous expectations. Heterogeneous expectations could result from
information asymmetry amongst individuals. An unresolved issue about market efficiency was whether
there is full aggregation or averaging of information in pricing. A fully aggregating market is said to be
consistent with the Fama͛s (1970) definition of strong form efficiency. In a fully aggregating market,
even insiders who possess private information would not be above to profit by it. Nevertheless,
empirical evidence on insider dealing suggests that insider can and do make abnormal returns. On this
basis, it can be said that capital markets do no instantaneously and fully aggregate information.

"

 '
   

 
Capital market efficiency relies on the ability of arbitrageurs to recognize that prices are out of line and
to make a profit by driving them back to an equilibrium value consistent with available information.
Given this type of behavioural paradigm, one often hears the following questions: If capital market
efficiency implies that no one can beat the market, then how can analysts be expected to exist since
they too, cannot beat the market? If capital markets are efficient, how can we explain the existence of a
multibillion naira security analysis industry? The answer, of course, is that neither of these questions is
inconsistent with efficient capital markets. First, analysts can and do make profit in a competitive
manner amongst themselves. If the profit to analysis becomes abnormally large, then individuals will
enter the analysis business until the abnormal profit becomes ͚wiped out͛. Cornell and Roll (1981) and
Elton, et al (1993) have shown that a sensible asset market equilibrium must leave some room for
analysis. Their articles make the more reasonable assumption that information acquisition is costly
activity. Cornell and Roll showed that it is reasonable to have efficient markets where people earn
different gross rates of return for the reason that they pay differing costs for information.
Nevertheless, net of costs their abnormal rates of return will be equal (to zero0. Elton, et.al (1993) show
that gains by professional fund managers appear to no more than cover the expenses of managing the
portfolios.
¢

  " #
Usually, a wide range of applications of capital market efficiency includes issues such as accounting
information, block trades, new issues of securities, stock splits, and portfolio performance
measurement.
¢ 
 

 
rusiness news takes various forms ʹ the announcement of a change in top management, the awarding
of a large contract to a competitor, analysts͛ reports, or a forecast of earnings by a firm͛s management.
The most extensively used sources of information, nevertheless, are the firm͛s published financial
reports. Published statements play a significant role in the dissemination of corporate information.
Specified the plethora of complex accounting procedures and principles, we would not expect all market
participants to be able to differentiate false or misleading information is based on various assumptions
and principles which authorize the use of alternative actions in various situations. Examples comprise
the timing of revenue and expense recognition (accrual concept), accounting for lease obligations and
mergers, inventory accounting technique, and son on (see Dyckman, et al, 1975:2-4).
In accounting terms the market value of assets is the present value of their cash flows discounted at the
appropriate risk-adjusted rate. Nonetheless, corporations report accounting earnings, not cash flow, and
regularly the two are not related. Empirical evidence shows that if investors really value cash flow and
not earnings per share (EPS), we would expect to see stock prices rise when firms.
Further, on accounting treatment of mergers and acquisitions, two possibilities exist: pooling or
purchase. In a pooling arrangement, the income statements and balance sheets of the merging firms are
simply added together. On the contrary, when one company acquires another, the assets of the
acquired company are added to the acquiring company͛s balance sheet along with an item called
goodwill. In an empirical study, hong, Kaplan and Madelker (1978) tested the effect of pooling and
purchase techniques on stock prices of acquiring firms. Using monthly data between 1954 and 1964,
they compared a sample of 122 firms that used pooling and 37 that used purchase. The acquired firm
had to be at least 3% of the net asset value of the acquiring firm.
rall and rrown (1968) used a procedure to assess the speed of adjustment of security prices to earnings
announcement in the Wall Street Journal. rall and rrown reasoned that the market participants would
have formed opinions reflected in their forecasts of what the earnings numbers should be, and,
collectively, these forecasts would be reflected in a market forecast of the stock͛s price. rall and rrown
used monthly data for a sample of 261 firms between 1946 and 1965 to evaluate the usefulness of
information in annual financial reports (AFRs). First, they separated the sample into companies that had
earnings that were either higher (͚good news͛) or lower (͚bad news͛) than market͛s forecast. The
market͛s forecast was based on a naïve time series model. Finally, estimated earnings changes were
compared with actual earnings changes. If the actual change was greater than estimated, the company
was put into a portfolio where returns were expected to be positive, and vice versa. In both cases (good
or bad news), the cumulative excess return displayed no significant behaviour in the months following
the earnings announcement. The study, thus, indicates that most of the information contained in the
AFRs is anticipated by the market before the AFRs are released. rrown and Kennelly (1972) found similar
results concerning market reaction to quarterly earnings reports. The rall and rrown study raised the
question of whether or not AFRs contain any new information. Griffin (1977), Foster (1977), rrown
(1978), Watts (1978), Aharony and Swary (1980), and Joy, Litzenberger and McEnally (1977) have
focused on quarterly earnings reports where information revealed to the market is (perhaps) more
timely than AFRs.
Trimonthly earnings reports are sometimes followed by announcements of dividend changes which also
have an effect on the stock price. To examine this problem, Aharony and Swary (1980) observe all
dividend and earnings announcements within the same period that are at least 11 trading days apart.
They conclude that both quarterly earnings announcements and dividend change announcements have
statistically significant effects on the stock price. rut more significant, they find no evidence of market
inefficiency when the two types of announcement effects are separated. Two studies, one by Pettit
(1972) and one by Watts (1973), measured the market͛s reaction to dividend announcements. Although,
the authors arrived at different conclusions concerning the significance of dividend changes to market
participants, the results of both studies are consistent with the behaviour implied by the EMH: there
was no evidence that a firm͛s dividend announcement affected the firm͛s security price in the periods
following the announcement. Handjinicolaou and Kalay (1984) and Woolridge (1983) have argued that
one cannot infer that dividend increases convey positive information about the firm by examing share
prices alone, since unexpected dividend increases could cause wealth transfers from bondholders to
shareholders by reducing the asset base of the firm. Hence, the observed increase in share price is
consistent with both wealth redistribution and positive information. To distinguish between the relative
significance of these two effects, Handjinicolaou and Kalay and Woolridge analyze the changes in bond
prices around dividend announcements since the two hypotheses (information and wealth transfer)
have different predictions for bond price behaviour. In particular, the wealth transfer hypothesis
predicts a negative bond price reaction while the information content hypothesis predicts a positive
reaction. The findings of these studies give strong support for the hypothesis that informational effects
dominate wealth redistribution effects wherever there are unexpected dividend increases.
rhana (1991) analyzed the share market response to considerable changes in dividend policies by
Johannesburg Stock Exchange (JSE) listed stocks during the period 1970-1988. The results give strong
support for the information content of dividends hypothesis. The empirical evidence suggests that large
dividend changes on the JSE convey important information to investors over and above that contained
in the earnings announcements. Further, in a subsequent research, rhana (2002) observes a sample of
100 companies announcing special dividends over the period ͞1975 ʹ 1994. Daily data on share prices
were obtained from the database of the JSE and ͞McGregor͛s Online Information Services. ͞The study
indicates stock price reaction to ͚labelled͛ (in the sense that it is only temporal or seasonal and is not
expected to be frequent) increases in dividends. It shows that share price reactions are negatively
related to dividend declaration frequency. This outcome suggests that market participants look forward
to the announcements of special dividends by companies that have numerous declarations of such
dividends. This, in turn, shows that request declaration of special dividends convey less information than
do rare declarations.
r
 
Scholes (1972) and Kraus and Stoll (1972) furnished the first empirical substantiation about the price
effects of block trading. Scholes used daily returns data to analyse 345 secondary distributions between
July 1961 and December 1965. Secondary distributions, unlike primary ones, are not initiated by the firm
but by shareholders who will receive the returns of the sale. The distributions are generally
underwritten by an investment banking group that buys the entire block from the seller. The shares are
then sold on a subscription basis after normal trading hours. Stock exchange or brokerage commissions
are not paid by the subscriber, he only pay subscription price. The issues here spin around the speed
with which the market adjusts to the effect of the block trade; the possibility of making abnormal
returns from price changes; the liquidity and/or information effects, etc. Fundamentally, the sale of a
large block may have two effects. First, if it is assumed to carry with it some new information about the
security, the price will change (enduringly) to reflect the new information. Second, if buyers must incur
extra costs when they agree to the block, there may be a (temporary) decline in price to reflect what has
been described as a price pressure, or distribution effect or liquidity premium. Scholes͛s study focused
only on permanent price changes.
Kraus-Stoll (1972) study associates to open market block trades. They analyzed price effects for all block
trades of 10,000 shares or more carried out on the NYSE between July 1, 1968 and September 30, 1969.
They had prices for the close of day prior to the block trade, the price right away before the transaction,
the block price, and the closing price the day of the block trade. Abnormal performance indices based on
daily data were constant with Scholes͛ results. More concerned were intraday price effects. There is
clear evidence of a price pressure or distribution effect. The stock price recovers significantly from the
block price by the end of the trading day. The recovery averaged 713%. Other studies on block trade
effects include Mikkleson and Partch (1985), Dann, Mayers and Raab (1977), and so on.
'  
Various articles that have analyzed the pricing of new issues of common stock comprise, but not limited
to, Reilly and Hatfield (1969), Stickney (1970), McDonald and Fisher (1972), Logue (1973), Stigler (1964),
and Shaw (1971). They all faced an apparently inexplicable problem: How could returns on unseasoned
issues be adjusted for risk if time series data on pre-issue prices were nonexistent? An ingenious way
around this difficulty was employed by Ibbotson (1975). Portfolios of new issues with identical seasoning
(defined as the number of months since issue) were formed. The monthly return on the XYZ company in
March 1964, say two months after its issue, was coordinated with the market return that month,
resulting in one pair of returns for a portfolio of two months seasoning. Ibbotson could compute a
covariance with the market from the collected vector of returns, and thus expected the respective
stocks͛ systematic risk. Applying the experiential market line, he expected abnormal performance
indices in the month of first issue (initial performance from the offering data price to the end of the first
month) and in the aftermarket (months following the initial issue). From 2650 new issues between 1960
and 1969, Ibbotson arbitrarily selected one new issue for each of the 120 calendar months.
The probable systematic risk in the month of issue was 2.26 and the abnormal return was estimated to
be 11.4%. Even after transaction costs, this makes up a statistically important provide abnormal return.
Therefore, either the offering price is set too low or investors systematically overvalue new issues at the
end of the first month of seasoning. Ibbotson concentrated on the possibility that offering prices
determined by the investment banker are systematically set below the fair market value of the security.
He asserted that the evidence cannot allow us to reject the null hypothesis that after markets are
efficient, although it is interesting to note that returns in 7 out of 10 periods show negative values.
Weinstein (1978) studied the price behaviour of newly issued corporate bonds by measuring their
excess holding period returns. Surplus returns were defined as the distinction between the return on the
th newly issued bond and a portfolio of seasoned bonds are similar to those of Ibbotson (1975) for
newly issued stock, namely, that the offering price is below the market equilibrium price but that the
aftermarket is well-organized. Weinstein found a .383% rate of return during the first month and only a
.06% rates of return over the next six months.
ãã
 
The best acknowledged study of stock splits was conducted by Fama, Fisher, Jensen, and Roll (1969).
Since stock splits are often linked with increased dividend payouts, it would be expected that split
announcements would contain some economic information. Cumulative average residuals were
calculated from the simple market model, using monthly data for a period of 60 months around the split
ex data for 940 splits between January 1927 and December 1959. Fama et. al. found that there was
considerable market reaction prior to the split announcement. In fact, the average cumulative abnormal
return for the 30-month period up to the month of announcement was in excess of 30%. This would
seem to point out that splits precipitate abnormal returns. Nevertheless, such a conclusion lacks
economic logic. The run-up in the cumulative average returns prior to the stock split can be explicated
by selection bias. The study recommended that stock splits might be interpreted by investors as a
message about future changes in the firm͛s expected cash flows. They speculated that stock splits might
be interpreted a message about dividend increases, which in turn entail that the managers of the firm
feel secure that it can maintain a enduringly higher of cash flows. To test this hypothesis, the sample
was divided into those firms that augmented their dividends beyond the average for the market in the
interval following the split and those that paid out lower dividends. The results reveal that stocks in the
dividend ͞increased͟ class have somewhat positive returns following the split. This is regular with the
hypothesis that splits are interpreted as messages about dividend increases. Nevertheless, a dividend
boost does not always follow a split. For this reason, the to some extent positive abnormal return for the
dividend ʹ increase group reflects small price adjustments that occur when the market is extremely sure
of the increase. On the contrary, the cumulative average residuals of split-up stocks with poor dividend
performance decline until about a year after the split, by which time it must be very clear that the
predictable dividend increase is not imminent. A synthesis that on average, the market makes unbiased
estimates about security returns and by extension, prices. The study confirms the semi-strong form of
efficiency. The split per se has no effect on shareholder wealth. Rather, it merely serves as a message
about the future prospects of the firm. Therefore, splits have benefits as signaling devices. There seems
to be no way to use a split to increase one͛s expected returns, unless, of course, inside information
regarding the split or succeeding dividend behaviour is available. rrennan and Copeland(1987) provide a
signaling theory explanation for stock splits and show that it is consistent with the data. This study
shows that the lower the target price to which the firm splits, the greater assurance management has,
and the larger will be the announcement residual.
h *

 
The performance of mutual funds has been examined by a number of authors such as Friend,
et.al.(1962) who examined 189 funds from December 1952 to September 1958; Friend and Vickers
(1965); Sharpe (1966) who scaled the performance of 36 mutual funds from 1954 to 1963; Treynor
(1965); Jensen(1968) whose analysis covered the period 1945 to 1964; Jensen (1969) covering 115
mutual funds from 1955 to 1964; Friend, rlume and Crockett (1970) who studied 136 mutual funds from
1960 into 1969; Williamson (1972) studied 180 mutual funds from 1961 to 1970. Even though the
samples of firms, time periods, and performance measures differed to some extent between these
studies, their results were extraordinarily similar. On the average, net of costs, mutual funds did no
better than an individual investor would expect if he purchased a diversified portfolio of similar risk. In
fact, when all the fund͛s expenses were well thought-out, a majority of funds did worse than a randomly
selected portfolio would have done. Therefore, these studies show that the net performance of mutual
funds is the same as that for a immature investment strategy.
ã

   " #
This section presents a concise mathematical representation of the various models that have found
extensive use in the EMH research.
¢ 
 
  

The model, suggested by Fama (1970), is given by:
Zi,t+1 M ri,t+1, ʹ E[ri,t+1/*t]
with E[zi,t+1,/*t] M 0
Where Zi,t+1, is the unexpected return for security  in period t+1, the difference between the observed
return ri,t+1, and the unexpected return based on the information set *t. The expected return could, for
instance, be determined by the CAPM.
r   
¢ 

¢ 
The CAPM, as developed by Sharpe (1964), Linter (1965) and Mossin (1966), may be mathematically
expressed as:
E(rit) M rft +[E(rmt) ʹ rft] ɴi + ɸit (r1)
Other CAPM ʹ related models are the market model and the empirical market line. The market models
argues that returns on any security are linearly related to returns on a ͞market͟ portfolio.
Mathematically described thus:
rit M ai +ɴi Rmt + ɸit (r2)
where E(ɸit) M 0
ʍ(Rmt, ɸit) M 0
ʍ(ɸit ɸit) M 0
rit M return on security  in period 
 rmt M general market factor in period t
ɸit M the stochastic portion of the individualistic factor representing the part of security i͛s return
which is independent of Rmt.
ai, ɴi M intercept and slope coefficients respectively, which are assumed to be constant over the
time period during which the model is fit to the available data.
It is instructive to note that the general market factor in equation (r2) is designed to reflect general
market and economic conditions that are related to the returns on a particular security. This is a
different notion than the return on the market portfolio in the CAPM given by rmt.
Sometimes, we see the empirical market line which is expressed as:
rit M Yot + Yit ɴit + ɸit (r3)
Although related to the CAPM, it does not require the intercept term to equal the risk ʹ free rate.
Instead, both the intercept Yot, and the slope. Yit, are the best linear estimates taken from cross-section
data each time period (typically each month). Furthermore, it has the advantage that no parameters are
assumed to be constant over time.
All three models use the residual term ɸit, as a measure of risk-adjusted abnormal performance.
Nevertheless, only one of the models, the CAPM, relies exactly on the theoretical specification of the
Sharpe-Litner-Mossin Model.
  ¢ 
     ¢
Performance measures of mutual funds include the Sharpe Index (reward to variability ratio), Treynor
Index and Jensen Abnormal performance.
Shape Index M (rit ʹ rft)/ʍi (C1)
Treynor Index M (rit ʹ rft)/ɴi (C2)
Abnormal Performance M ait M (rit ʹ rft) ʹ [ɴi (rmt ʹ rft)] (C3)
Where
ri M return of the ith mutual fund
rf M return on a risk free asset (generally Treasury bills)
ʍi M the standard deviation of return on the ith mutual fund
ɴi M the estimated systematic risk of the ith mutual fund
Accordingly the researchers have used the models above together with the expected-returns and CAPM
to examine empirically the effects of accounting numbers. One of other more imaginative developments
in this approach was the API by rall and rrown (1968) to study the association between unexpected
changes in accounting earnings and unexpected changes in prices. The unexpected price changes are
aggregated (for portfolios formed using the sign of the earnings forecast error) using the relationship:
API M 1 ѓ(1 + ɸit) ʹ 1 (C)
Nit
where
T M number of time periods: t M 1,2, ͙. , T
N M number of securities: I M 1,2, ͙. , N
ɸit M individualistic component of rit, or, alternatively, the forecast error.
The API traces out the value of a naira invested in equal amounts in each security in the portfolio from
time t up to T. At time T the earnings number is assumed to be made public.
As reaver (1972) notes, the API has an appealing intuitive interpretation. It represents one measure of
the value of the information contained in the earnings number (actually the sign of the earnings forecast
error) T months prior to the release of the earnings number. In this sense, the API concept has some
aspects of similarity to the notion of perfect information as the concept is used in decision theory. The
analogy is not perfect, nevertheless, for the API is an ex post concept while the value of perfect
information is an ex ante notion.
It suffices to note that the discussion of the foregoing models given here is intentionally brief. A more
extensive coverage is available in reaver (1972). Dyckman et. al. (1975), Copeland and Mayers (1982),
Sharpe and Cooper (1972), and rrealey & Myers (1996).
h ¢¢"<c¢;¢"c¢"ã¢c¢ h¢¢ "*ã(¢h )
A purpose of accounting information is to reduce uncertainty about a state of affairs. To achieve this
objective, accounting researchers and writers have, generally, advocated more accounting information
revelation. For instance, in the Nigerian context, Inanga (1976) indicated that the information content of
published AFRs of public companies are insufficient for the users͛ requirements. He has, hence,
suggested the disclosure of other information such as protected cash flow and future dividend levels.
Some scholars have noted, nevertheless, that the message which contains the principal number of bits
of information does not essentially lead to the highest payoff (with respect to extent of vagueness
reduction). Also, the incremental benefit of any additional disclosure depends upon the measure of
sufficiency of the accessible information set. For this reason, it is noted that it is always preferable to
assess the extent to which the existing information set meets the users͛ requirements to enable one to
determine the extent of the need for extra information disclosure. This view is consistent with the
information economics approach to accounting information disclosure decisions. It treats information as
any other (normal) economic good, the demand for which constitutes a problem of economic choice.
The additional revelation syndrome overlooks problems relating to the limited capacity of people at
processing information and those of information overload. Moreover, empirical evidence has indicated
that the usefulness of an information item to a decision task may be dependent upon the availability or
non-availability of other competing information in the decision environment. For example, empirical
research efforts in accounting and efficient markets has been to see if accounting provides information
to the market. Studies indicate a market reaction that is anticipatory to the release of accounting data.
For this reason, AFRs do not possess a monopoly on these data and competing sources may shovel their
formal release. This insight tends to diminish the perceived information content of accounting reports.
In a related research, carried our by Ariyo & Soyode (1985), on information sufficiency and redundancies
contained in published AFRs. Furthermore, the results of the correlation matric among the variables
used for the regression analysis, shows a high degree of intercorrelation among the selected variables
(cues). The results, hence, suggest a great deal of redundancies in the simultaneous disclosure in reports
of data relating to earnings, dividends, and cash flow. The results further show that the gearing ratio
(GR) data is not considerably correlated with any of the other cues, suggesting that information
conveyed by GR is different from those of other cues.
The Ariyo & Soyode study sought to evolve an optimal trade-off between lack of relevant information
and over-abundance of immaterial information. The study suggests that it is desirable to recognize the
type of additional information necessary to avoid over-supply of superfluous information.

ã

Numerous scientific research focusing on the stock market has not only developed new theories on
capital markets but refined existing ones which are regarded sophisticated and efficient in the
explanation of pertinent information. The key focus of this chapter was to review some past financial
studies on market efficiency particularly informational efficiency with a vision to bringing out the
behavioral pattern that reflects the Efficient Market Hypothesis dependence on the activities of
arbitrageurs and experts who create demand and supply patterns to sustain the market in equilibrium. It
is also showed that the value of any information structure should be regarded as net of costs, so that
any claim to abnormal returns as a result of monopoly of relevant information may not be important
relative to the cost of obtaining the information which is applicable to both portfolio managers and
individual investors. In this chapter, we considered the affect of accounting information on stock prices;
block trades; new issues; stock splits and mutual fund performance. Most of the evidence are constant
with the weak and semistrong forms of market efficiency but irregular with the strong form. In certain
states of affairs, individuals with inside information appear to be able to earn abnormal returns. This fact
may depict an informational inefficiency rather than general which lend authority to the theory of
arbitrage capital markets inefficiency. Furthermore, block traders can earn abnormal returns when they
trade at the block price as in purchases of innovative equity issues. Additional research could be
performed on the impact of capital structure decisions of firms on stock prices..
A rising field of research, referred to as rehavioural Finance, studies how cognitive or emotional biases,
which are individual or collective, create anomalies in market prices and returns and other deviations
from the EMH. rehavioural models usually put together insights from psychology with neo-classical
economic theory. Nevertheless, EMH proponents opine that any observed anomalies will eventually be
priced out of the market or explained by appeal to microstructure. They further show the inevitability to
differentiate between individual biases and social biases; the former can be averaged out by the market,
while the other generate feedback loops that drive the market further away from the equilibrium of the
͚fair price͛.

"9":<c"ãã
1. Suppose you know with certainty that the ArC Capital Corporation will pay a dividend of TZS10
per share on every January 1 forever. The continuously compounded risk-free rate is 5% (also
forever).
(a) Graph the price path of Clark Capital common stock over time.
(b) Is this (highly artificial) example a random walk? A martingale? A submartingale? (Why?)
2. Given the following situations, determine in each case whether or not the hypothesis of an
efficient capital market (semistrong form) is contradicted.
(a) Through the introduction of a complex computer program into the analysis of past stock
price changes, a brokerage firm is able to predict price movements well enough to earn a
consistent 3% profit, adjusted for risk, above normal market returns.
(b) On the average, investors in the stock market this year are expected to earn a positive
return (profit) on their investment. Some investors will earn considerably more than others.
(c) You have discovered that the square root of any given stock price multiplied by the day of
the month provides an indication of the direction in price movement of that particular stock
with a probability of .7.
(d) A securities and Exchange Commission (SEC) suit was filed against Tanzania Sulphur
Company in 1965 for the reason that its corporate employees had made unusually high
profits on company stock that they had purchased after exploratory drilling had started in
Dar es Salam (in 1959) and before stock prices rose dramatically (in 1964) with the
announcement of the discovery of large mineral deposits in Dar es Salam.
3. The First National rank has been losing money on automobile consumer loans and is considering
the implementation of a new loan procedure that requires a credit check on loan applicants.
Experience indicates that 82% of the loans were paid off, whereas the remainder defaulted.
Nevertheless, if the credit check is run, the probabilities can be revised as follows:
 Favourable Unfavourable
Credit Check Credit Check

Loan is paid .9 .5
Loan is defaulted .1 .5
An estimated 80% of the loan applicants receive a favourable credit check. Assume that the
blank earns 18% on successful loans, loses 100% on defaulted loans, and suffers an opportunity
cost of 0% when the loan is not granted and would have defaulted. If the cost of a credit check is
5% of the value of the loan and the blank is risk neutral, should the blank go ahead with the new
policy?
4. Tanzanian Foods Ltd., one of the nation͛s largest consumer products firms, is trying to decide
whether it should spend TZS5 million to the test market a new ready-to-eat product (called
Kidwich), to proceed directly to a nationwide marketing effort, or to cancel the product. The
expected payoffs (in millions of TZSs) from cancellation versus nationwide marketing are given
below:
¢
 

   .
 

  

'

No acceptance 0 ʹ10
Marginal 0 10
Success 0 80

Prior experience with nationwide marketing efforts has been:


 

  *
$$


No acceptance .6
Marginal .3
Success .1
If the firm decides to test market the product, the following information becomes available:
  

 

 ã 
¢ 
Outcome Predicted by the No Acceptance .9 .1 0
Test Market
Marginal .1 .7 .2
Success .1 .3 .6
For example, if the test market results predict a success, there is a 60% chance that the nationwide
marketing effort really will be a success but a 30% chance it will be marginal and a 10% chance it will
have no acceptance.
(a) If the firm is risk neutral, should it test market the product or not?
(b) If the firm is risk averse with a utility function
U(W) M ln(W + 11),
should it test market the product or not?
5. The efficient market hypothesis implies that abnormal returns are expected to be zero. Yet in
order for markets to be efficient, arbitrageurs must be able to force prices back into equilibrium.
If they earn profits in doing so, is this fact inconsistent with market efficiency?
 6. Read the following:
(a) In a poker game with six players, you can except to lose 83% of the time. How can this
still be martingale?
(b) In the options market, call options expire unexercised over 80% of the time. Thus the
option holders frequently lose all their investment. Does this imply that the options
market is not a fair game? Not a martingale? Not a submartingale?
7. If securities markets are efficient, what is the NPV of any security, regardless of risk?
8. From time to time the federal government considers passing into law an excess profits tax on
U.S. corporations. Given what you know about efficient markets and the CAPM, how would you
define excess profits? What would be the effect of an excess profits tax on the investor?
9. State the assumptions inherent in this statement: A condition for market efficiency is that there
be no second-order stochastic dominance.

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    ¢
 
Tanzania embarked on a programme of privatization in the early 1990s as it shifted away from being a
quasi-socialist to a more market driven economy. As part of this initiative, efforts were made to develop,
broaden and deepen the financial sector. This included providing opportunities for broader local
ownership and expanding long term financing alternatives and opportunities through the development
of capital markets.

The first step in furthering the development and expansion of capital markets in Tanzania was the
creation of an overall regulatory agency, the Capital Markets and Securities Authority (The Securities
Authority). The agency was established under the Capital Markets and Securities Act, 1994 (The
Securities Authority) as an autonomous body ͞for the purpose of promoting and facilitating the
development of an orderly, fair and efficient capital market and security authority in Tanzania͟. The
Securities Authority is the regulatory and supervisory body for the capital markets. It licenses and
regulates investment intermediaries and investment professionals, monitors and regulates exchanges
and supervises the issuance of and trade in securities. The Securities Authority has since promulgated a
number of rules and regulations including those covering guidelines for the issuance of corporate bonds
and commercial paper and disclosure guidelines for cross-listing.
A necessary adjunct to the creation of the Securities Authority was the establishment of the Dar es
Salaam Stock Exchange (DSE). The DSE was incorporated in September 1996 as a private company
limited by guarantee with the purpose of facilitating the implementation of financial sector reforms,
encouraging wider local share ownership in all companies and facilitating the raising of medium and
long-term capital.
Trading activities at the DSE commenced on April 15, 1998. Currently the DSE has only the Main
Investment Market Segment which is an amalgam of main investments and fixed income securities. An
Entrepreneurship Growth Market and an Alternative investment Market are in the process of being
created.
More than 10 years later, the DSE has 11 domestic companies listed and four foreign cross-listed
companies whose total market capitalisation is valued at approximately $3.7bn. In terms of the number
of companies listed, the DSE is behind the Nairobi Stock Exchange (NSE) but ahead of the Uganda
Securities Exchange (USE) and the Rwandan Capital Markets Advisory Council (CMAC).
The NSE was formed in 1954 and is one of the most active capital markets in Africa with more than 50
listed companies. The USE, which was launched in June 1997 and started trading in January 1998, is
operated under the jurisdiction of the Capital Markets Authority, which reports to the Central rank of
Uganda and has 12 listed companies of which five are foreign cross-listed companies. The CMAC was
established by a prime-ministerial decree in March 2007 and is comprised of a roard of Directors and a
Secretariat. The latter oversees the day to day operation of the Rwanda Over-the-Counter Exchange
which at present has seven listed companies. 

 $



 
" ¢


Cross-border listing, where a firm lists its equity shares for trading in a stock exchange located in a
different country has gained significance in East Africa over the past years since the signing of the Treaty
for the Establishment of the East African Community (the Treaty). Article 85 (ranking and Capital Market
Development) of the Treaty states that the Partner States must undertake to implement within the East
African Community (EAC), a capital market development program to be determined by the Council for
the purpose of creating a conducive environment for the movement of capital within the EAC.
Furthermore the Partner States (which as of July 2009 consisted of Tanzania, Kenya, Uganda and
Rwanda) were specifically tasked with promoting co-operation among the stock-exchanges and the
capital markets and securities regulators in the EAC. This included establishing within the EAC a
mechanism for cross-listing stocks, a rating system of listed companies and an index of trading
performance to facilitate the negotiation and sale of shares within and external to the EAC.
Further, the Securities Authority issued the Capital Markets and Securities (Foreign Companies Public
Offers Eligibility and Cross Listing Requirements) Regulations 2003 and the Capital Markets and
Securities (Foreign Companies Public Offers and Cross Listing Requirements) Amendment Regulations,
2005 (͞The Regulations͟) which are read together and govern the cross listing process.
At present, Tanzania has four cross-listed companies (Kenya Airways, East African rreweries, Jubilee
Holdings and Kenya Commercial rank). Their market capitalisation is approximately $2.5bn or more than
double the market capitalisation of the domestic listed companies.
 
 
The regulations apply to all offers of securities to the Tanzanian public by foreign companies which,
subsequent to a public offer, intend to list on the DSE as well as to other foreign companies that intend
to apply for cross-listing on the DSE.
Each foreign company applying for cross-listing must establish a place of business in Tanzania and
register as a foreign company under the Companies Act, 2002.
A foreign company is then eligible to issue securities to the public in Tanzania subject to the following:
i) Compliance with the provisions of Part XII of The Securities Act, which deals with prospectus
requirements, advertisements and compensation;
ii) Listing such securities at a stock exchange in Tanzania subsequent to such public offer; and
iii) Compliance with the First Schedule of The Regulations which requires verification that the
laws under which the foreign company is incorporated impose similar requirements as the
Companies Act, 2002.
The execution of a Memorandum of Understanding (MOU) between the securities regulator in the
jurisdiction where the applicant is listed and the foreign company and the execution of a MOU between
the exchange where the applicant͛s securities are listed or where listing is being sought and the DSE will
satisfy the requirements of the First Schedule of the Regulations. However, the First Schedule can also
be satisfied if the securities regulator of the country where the company is listed is a signatory to a
relevant multilateral MOU of which Tanzania is also a signatory.
An applicant seeking to cross-list in the first tier market of the DSE must be listed in a similar market in
other countries where it is listed or cross-listed. Also the company must have minimum issued and fully
paid up capital of not less than $700,000 and have net assets of not less than $1.4m.
Other requirements include:
ͻ securing at least 1,000 shareholders of which at least 25 percent must be held by the public; and
ͻ publication of audited financial statements complying with International Accounting Standards
for at least five years and which show the company was profitable for at least three of the past
five years; and
ͻ approval of an Information Memorandum by the Securities Authority.
Part Two of the Second Schedule of the Regulations prescribes the form and content requirements of
the Information Memorandum. The regulations reflect international norms regarding disclosure
requirements.
Lastly the securities regulator and the stock exchange of primary listing must each upon notification
transmit to the Securities Authority a confidential report on the foreign company regarding the
compliance history of the company with the regulations of the stock exchange of primary listing.
 +
@ 
 
In 2002 the Securities Authority enacted the Guidelines on Corporate Governance Practices by Public
Listed Companies in Tanzania (the Governance Guidelines) ͞with the ultimate objective of realising
shareholders long-term value while taking into account the interest of other stakeholders͟. At the core
of the Governance Guidelines is an effort to promote a high standard of self-regulation within public
listed companies in Tanzania and achieving an international standard of governance. The provisions
highlight practices relating to the board of directors, audit committees, supply and disclosure of
information, shareholder participation, etc. Emphasis extends beyond descriptions of accountability
within respective roles to principles of operation aimed at fostering efficient communication both within
the company and between the company and the Securities Authority. Good corporate governance has
become increasingly significant given the multifaceted nature of cross-border listings. Thus, the Partner
States are continuing to develop strategies in this area as they work towards attaining a smoother flow
of capital in the East African region.
 

%

  
In addition to the annual listing fee of 0.05 percent of the market capitalisation of the listed securities
and the holding of annual shareholder meetings, listed companies are required to submit semi-annual
financial reports to the DES and also to notify the DSE and the public of any previously undisclosed price
sensitive information. There are also on-going corporate governance reports regarding the progress
attained in complying with the Governance Guidelines.
  
 
Tanzania provides numerous incentives for issuers and investors participating in the DSE. They include a
reduced corporate income tax rate of 25 percent for three years where 35 percent of the issuer͛s shares
are held by the public as opposed to a 30 percent rate for unlisted companies. Investors of publicly
traded companies realise a zero capital gains tax as opposed to a 10 percent tax on shares of unlisted
companies. They also receive a five percent withholding tax on dividend income as opposed to 10
percent on dividends from unlisted companies.
 '
'

The development of cross listing across national stock markets in Tanzania, Kenya, Uganda and Rwanda
is a milestone in the EAC͛s drive for regional integration. Despite barriers such as wavering political will,
differences in settlement procedures and still relative illiquidity, the EAC͛s stock markets are braced for
continued growth, access and harmonisation. With the emergence of electronic gateways, perhaps a
regional stock market is not lingering too far in the future?
To properly navigate and take advantage of the dynamic opportunities offered by the East African
capital markets it is advisable to hire a reputable and experienced law firm such as Mkono & Co
Advocates with regional offices and formal international affiliations.
ã
: www.mkono.com
< 
 

1. What shifted away Tanzania from being a quasi-socialist to a more market driven economy?
2. Do you think that the initiative taken by the government of Tanzania to attract foreign
companies and investors would give boost to the national economy? Give your comments with
suitable examples.
 c
6

"

 
 
 "
 

Empirical evidence for or against the hypothesis that capital markets are efficient takes many forms.
Most of the people and scholars do agree that capital markets are efficient in the weak and semistrong
forms but not in the strong form. Generally capital market efficiency has been tested in the large and
sophisticated capital markets of developed countries. Hence one must be careful to limit any
conclusions to the appropriate arena from which they are drawn. Research into the efficiency of capital
markets is an ongoing process, and the work is being extended to include assets other than common
stock as well as smaller and less sophisticated marketplaces.

Prices in informationally efficient capital or financial markets should be a sign of all accessible
information. A significant result of market efficiency is that investments in publicly traded financial
securities, such as stocks and bonds, are zero NPV investments (as opposed to the assumed positive
NPVs of most real or productive assets). Investors should anticipate to earn a fair or normal return that
is consistent with the risk (defined by CAPM or APT) of the security. Companies should anticipate to get
a fair price when they issue securities. Present prices should symbolize a fair and impartial forecast or
approximation of the true, intrinsic, or fundamental value of the firm, i.e., the Present Value of all future
anticipated cash flows. If this were not the case, we would find a lot of instances where security prices
were systematically biased, i.e., either consistently underpriced or overpriced.
ã
  ' 


 




  
1. It impacts the price that the firm will receive for any new stocks and bonds that it may issue.
Also, if a firm can sell new stock that is overestimated, it is possibly likely to do such.
2. It affects the cost of capital or necessary rate of return on securities. The cost of capital affects
the capital budgeting or new capital expenditure decisions.
3. If you want to link management compensation to stock price or shareholder value, then it is
particularly significant that the stock price be representative of the true value of the firm, i.e.,
stockholders want a stock price that is fair and impartial.
4. An asset͛s price should be driven by impartial estimates of future cash flows and the true
systematic risk connected with the cash flows. If this were not the case, investors would be able
to earn returns that are contradictory with the true level of risk of an asset. Portfolio managers
are very interested in any mispricing in the stock market. A mispriced stock would be thought of
as cash lying in the street waiting for someone to pick it up.


 ¢$ 


If financial markets are not capable, then strategies would survive that can methodically earn above
normal or below normal returns, referred to as abnormal returns. Nevertheless, in order to actually
calculate any irregular return for any given asset, we first need some Asset Pricing Model such as the
Arbitrage Pricing Theory or Capital Asset Pricing Model that gives us an estimate or idea of what the
normal or predictable return to that asset should have been.
Abnormal Return M Actual Return observed ʹ Anticipated Return
The anticipated or normal return of the asset is based on: (1) the stock͛s level of risk and (2) what
actually happened with the relevant systematic or macroeconomic source(s) of risk. For instance, in a
CAPM world, if the overall market goes down, the stock under investigation would likely also have gone
down in price.

 ã*

' 

 
In an efficient market, prices respond instantaneously to new and material information and fully reflect
that information. Delayed responses (under-reaction) and overreaction to new information would
suggest that markets are inefficient. Next, we look at three information sets and the corresponding level
or form of market efficiency.
 

  h
 "

  
# 
(" #)
Three information sets are used to describe the EMH. Note that set 1 is a subset of 2 and that both 1
and 2 are subsets of 3. Each set corresponds to one form of the EMH as discussed below.
1. Historic stock prices and other market related information (e.g., trading volume, etc.)
2. Publicly accessible information (this also includes all historical market information)
3. All information relevant to a stock (both public and private information)


 "

  
# 

" #
0 : 
 

 : asset prices already replicate all historical market related trading
information such as past prices, returns, trading volume, or trends in volume or prices. The
majority of tests show that this information cannot be used to produce or earn abnormal
returns after adjusting for risk. This makes sense for the reason that this information is
accessible at almost zero cost. If the market is weak-form capable, then technical analysis or
chart reading should not produce abnormal returns. Stock prices should strongly follow a
random walk. Individuals have a fateful tendency to look for patterns or trends, even in random
series. Take a good look at the four graphs on page 10 of these notes. Two of the graphs are
actual performance of the U.S. market for a 10-year period, and the other two are computer
generated from a random walk model (an upward trend of 10 percent per year with 20 percent
annual standard deviation).
40 ã
A 
  
 

 : asset prices already reflect all information that is publicly
accessible, i.e., earnings, dividends, analyst forecasts, expectations of the future, etc. Most tests
show that material public announcements are accompanied by an immediate change in price. In
a semi-strong efficient market, the market's reaction to new and material information should be
both instantaneous and unbiased, i.e., without any systematic pattern of over or under reaction.
In addition, the market should only react to the extent that new information differs from what
had been anticipated. Semi-strong efficiency also means that most financial analysis work or
fundamental analysis, based on using public information, should not work. Opportunities may
occasionally exist that produce above normal or excess returns. Nevertheless, after the
information or strategies become known to the public, they should no longer produce excess
returns; e.g., the January effect in small stocks has vanished. Also, a talented investment analyst
might still be able to beat the market, provided that he/she is able to consistently interpret
information better than the competition can.
60 ã
  
 

 : asset prices by now replicate all private and public information. We
know that inside information is very important to anybody that chooses to (illegally in most
cases) act upon this information, so the market is undoubtedly not strong form efficient.


  ã
Aã
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"

 
! Stock prices are anticipated to increase over time, but future returns are anticipated to be
consistent with the systematic risk.
! Investments in financial assets are anticipated to be ZERO Net Present Value. This means that
you should expect to earn an average future return that is determined by the systematic risk of
the investments.
! What if no one performed security analysis? Then the first person that becomes an analyst will
find numerous mispriced assets and trading rules that earn excess or abnormal returns. Such
profitable opportunities would surely direct to many more individuals entering the analyst field.
Competition will speedily start to abolish most of the mispriced assets.
 ! recause of the intense competition, it will become complicated to earn abnormal returns. The
marginal benefit of analysis will just equal the marginal cost of analysis for the average analyst
or investor.
! It therefore follows that individuals should be exceptionally apprehensive of anyone that
advertises some investment technique that earns unusual returns. If the technique really works,
then any normal person would keep the method undisclosed! This holds for the weak-form
market efficiency as well, as many attempt to sell methods for technical analysis.
 "
 
 
"

 
! Are markets strong form efficient? Certainly not.
! Are markets weak-form efficient? Evidence strongly suggests yes. Random successes look
appealing, but most tests are not supportive of trading strategies that use market related data.
! Are markets perfectly semistrong efficient? No. The recent bubble in internet/technology stocks
is a somewhat obvious example of prices not reflecting their fundamental value.
! Are markets largely semistrong efficient? Yes, based on most of the evidence, especially for
event studies and mutual fund performance.
Nevertheless, there are several reported anomalies in stock prices. Do these anomalies represent actual
mispricings that a shrewd portfolio manager can convert into abnormal returns (ARs)? No, for the most
part. Perhaps they once worked, earlier than they became public knowledge. Also, what might produce
apparent or measured abnormal returns on paper might be difficult to really put into practice using
actual money.
   " # 

&


 
1. Tests for random walk in stock prices
2. Event Studies
3. Performance of professional investors
All these tests evaluate observed stock returns next to returns predicted by the EMH, controlling for
systematic risk. We first need to understand what any stock's normal returns should look like, based
upon its level of risk. Hence, tests of the EMH are joint tests of market efficiency and the asset pricing
model (e.g. the CAPM or APT) used to guess systematic risk.
   :h
" #(

 ' :B)
Tests for serial correlation are often used to test the weak form EMH. Positive serial correlation: above
(below) normal returns are followed by subsequent above (below) normal returns, or else referred to as
momentum. Negative serial correlation: above (below) normal returns are followed by succeeding
below (above) normal returns, or else referred to as reversals in returns. roth positive serial correlation
and negative serial correlation would entail violations of the weak form EMH if they are found to exist
and also if they are economically important after accounting for transactions costs. The greater part of
empirical evidence is dependable with the weak form EMH.
  ã
A 
 h
"

 
Event studies seem at stock price reaction to new information unconfined to the public. Delayed
responses or overreaction to new public information entails a violation of the semi-strong form EMH.
There is a little varied pragmatic evidence from event studies, but efficiency is generally supported. In
addition, the problem of jointly testing the underlying asset pricing model and market efficiency is still
unresolved, i.e., first you need to know what the normal returns should look like before any inference
can be made relating to market efficiency. Also, always remember that the true asset pricing model is
not known.
Mutual fund performance studies evaluate the return on actively managed mutual funds to returns on a
passive broad-based index mutual fund, e.g., a mutual fund that only attempts to match the S&P 500 or
Willshire 5000 indices. Since trading on insider information is illegal, the majority of active fund
managers have to depend on public information to prepare their investment strategies. The greater part
of mutual fund studies find that most active mutual fund managers do not do better than passive index
funds, supporting the semi-strong form EMH. The Value Line Investment Survey publishes information
about stocks that have broad investor interest. Value Line ranks stocks on a scale from 1 to 5. The stocks
ranked 1 and 5 are anticipated to have the best and worst future performance, in that order. Research
has shown that, on paper, the 1 ranked stocks have without a doubt outperformed the 5 ranked stocks.
Nevertheless, the two mutual funds that Value Line manages have in fact underperformed the market,
even though they use the Value Line ranking system in formulating their investment decisions. In fact,
what looks great on paper cannot always be implemented to produce above normal returns.
ã 

9
'  " #
ã
+: Studies have revealed that small firms (measured by market capitalization) earn higher returns
than huge firms after adjusting for systematic risk (reta CAPM risk in these studies). One disagreement
on this finding is whether a correct or correctly particular asset pricing model was used to adjust for
systematic risk. Returns cannot be said to be above or below normal when you don't have an excellent
idea of what the "normal" returns should look approximating.
In any case, small firms do not comprise much value in the overall market. Of all the publicly traded
firms in the U.S., the largest 10 percent of firms make up around 85 percent of the total value of the U.S.
stock market. The smallest 10 percent of firms make up only about 0.3 percent of the overall market
value. Even the smallest 30 percent of firms only make up about 2.5 percent of the overall market value.
! 
 ¢ 
 : Researchers discover several stylish facts (patterns) in stock returns,
implying that stock prices do not follow a random walk. Nevertheless, these findings are not
strong evidence against the EMH for the reason that these patterns cannot be exploited to earn
abnormal profits after accounting for transaction costs. Furthermore, one of these patterns
(negative average return on Mondays) has disappeared recently.
! 9 
  .
: This is the latest battleground for the EMH. Several studies show that
public information (the ratio of book value of equity to market value of equity or rV/MV) can be
used to select stocks that produce abnormal returns. If the finding is not driven by risk, then a
challenge to the EMH exists. The verdict on this topic is still not in.
!  A
 
 : Many studies, beginning in the early 1990s suggested that the market does
not completely or fully react to major corporate events, and long-term (1 to 5 year) abnormal
returns exist. This evidence of long-term anomalies following IPOs, stock splits, dividends, stock
repurchase announcements, etc. is controversial. The IPO underperformance study by Ritter
(1991) is well known and cited in the textbook. Misspecified asset pricing models are the likely
cause of most of these findings. More recent studies that use improved asset pricing methods or
models have explained or resolved many of these long-term anomalies.


 


h
 
  

1. Can financial managers ͞fool͟ investors?
Early studies find that stock prices do not react to changes in accounting methods, unless cash
flow is affected. These findings are consistent with the semi-strong form EMH and suggest that
restating financial accounting performance or methods is unlikely to increase value unless it can
also decrease taxes, bankruptcy costs, or agency costs. Nevertheless, well known recent
scandals at Enron, Worldcom, and Tyco, etc., illustrate that managers can sometimes fool the
public and investors with deceptive financial accounting practices, but only for so long before
the bubble bursts. Perhaps a firm can fool the market only once!
2. Can financial managers ͞time͟ security sales?
The market usually reacts negatively to an announcement of a sale of new common stock.
Nevertheless, early long-term studies found that theses firms have negative abnormal returns in
following years (firms that repurchase equity had positive abnormal returns in following years).
 These findings suggest that managers ͞time͟ equity sales and repurchases correctly. These
studies are controversial and have been largely resolved in recent years.
ã
r$$ 
Sometimes asset prices tend to reach elevated levels (sort of like Alan Greenspan͛s 1996 quote of
͞irrational exuberance͟) that are highly inconsistent with fundamental value. Prices of stocks,
particularly in a certain industry or sometimes in an entire market, appear to be priced at a level that is
far above what would be considered to be a fair price that is based upon risk and realistic anticipated
future cash flows. There is what some call the ͞bigger fool͟ theory. Someone might have felt like a
͞fool͟ for buying Cisco Systems stock in early 2000, but they were hoping that an even more foolish
person would soon come along and pay an even higher price. This, of course, can only continue so long
before prices eventually crash.
In each case of a speculative bubble, asset prices rise to high levels that cannot be sustained. The prices
cannot be justified by the asset͛s future cash flows, investors begin to realize this, and prices come
crashing down and eventually converge around the fundamental price. Some instances of what are
thought to be speculative bubbles in the past include the following:
1. Dutch tulip bulb mania of the early 1600s. A classic case of people turning away from their
normal productive activities in order to chase the bubble of rising tulip bulb prices.
2. South Sea bubble of the early 1700s in rritain.
3. Electric related stocks in the 1880s (yes, this was once new, exciting, and overpriced).
4. U.S. stock market of the late 1920s. Crash began in October 1929 and prices fell for the next 3
years. Take a look at Radio Corporation of America (RCA) stock during this period. RCA was the
͞new economy͟ stock of its era.
5. ͞Tronics͟ boom of the early 1960s. U.S. electronic stocks experienced a bubble.
6. ͞Nifty Fifty͟ craze of the early 1970s. A bubble in large market capitalization growth stocks, e.g.,
IrM, Xerox, McDonalds, Polaroid, Disney, Sony, etc. These were thought of as rlue Chip stocks
that would always be prudent investments for a portfolio, almost regardless of the price paid,
since these firms had a history of excellent corporate performance. Price-to-Earnings or P/E
ratios of these large company stocks were 60 to 80, while the P/E for the rest of the market was
around 15. Nevertheless, no large company can ever grow at a future rate that justifies a current
P/E of 60 to 90. This is a classic case of ͞good company, bad stock͟, in which the firm has a
bright future, but its stock is simply overpriced (such as the much later case of Cisco Systems in
2000). The Nifty Fifty stocks were hard hit in the recession of 1973 to 1974, typically losing 70 to
80 percent of their value.
7. Japanese stock and real estate bubble of the late 1980s. Nikkei 225 index almost hit 40,000 on
the last trading day of 1989. There was no way to justify these prices, which came at a time
when Japanese corporate profitability was actually declining. Two years later in 1992 the Nikkei
was below 14,000, and even in early 2003, it was below 8000. At the bubble͛s peak, the
appraised value of all real estate in metropolitan Tokyo exceeded that of the entire United
States.
8. Internet and dot.com bubble of 1999 and 2000, accompanied by the idea that we had entered
into the ͞New Economy͟, i.e., the ͞rules͟ had changed. New industries are often difficult to
assess or evaluate and often can be prone to irrational speculation. New industries go on to be
part of everyday life, but several have experienced a bubble during their infancy.
During any bubble, many believe that ͞this time it͛s different and the old rules no longer apply͟. Such an
attitude was certainly true of the Internet bubble. During the Internet bubble one would actually
repeatedly hear and read that the ͞old methods͟ of stock valuation (essentially discounted Free Cash
Flow to Equity) no longer worked in the ͞New Economy͟! The bubbles represent deviations from
fundamental or true value and thus represent a violation of market efficiency. Nevertheless, in each
case, the mispricing was eventually corrected in the marketplace. A major downside is that a bubble also
represents a temporary misallocation of resources in the economy. The economic slowdown during
2000 and recession of 2001, following the collapse of the Internet/technology bubble, is no mere
coincidence. The figures on page 9 illustrates the before and after phases of the Japanese stock market
bubble (the Nikkei 225 index) and the Internet bubble (showing the Nasdaq Composite Index,
Philadelphia Internet Index, and Cisco Systems stock). The technology laden Nasdaq Composite Index
reached 5000 at the peak of the Internet bubble. The figures on page 10 illustrate the U.S. stock market
bubble and the RCA (radio) bubble of the late 1920s.
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refore discussing the empirical tests of market efficiency, it is worth to review four basic types of
empirical models that are frequently employed. The differences between them are crucial. The simplest
model, called the market model, simply argues that returns on security  are linearly related to returns
on a ͞market portfolio.͟ Mathematically, the market model is described by
ájt M j + á + ɸ  (3.1)
The market model is not supported by any theory. It assumes that the slope and intercept terms are
constant over the time period during which the model is fit to the accessible data. This is a strong
assumption, particularly if the time series is long.
The second model uses the capital asset pricing theory. It requires the intercept term to be equal to the
risk-free rate, or the rate of return on the minimum-variance zero-beta portfolio, both of which change
over time. This CAPM based methodology is given by Eq. (3.1):
    
     h 
 
Now, nevertheless, that systematic risk is assumed to remain constant over the interval of estimation.
The use of CAPM for residual analysis was explained at the end of previous unit.
Third, we sometimes see the empirical market line, which was explained earlier in unit 1 was given by
equation:
 
   V 
V | h 
 
Although related to the CAPM, it does not require the intercept term to equal the risk-free rate. Instead,
 
both the intercept, V  , and the slope, V | , are the best linear estimates taken from cross-section data
each time period (typically each month). Furthermore, it has the advantage that no returns, for instance,
  

h|       
h
     
h     !    !  
  (3.2)
In this fourth equation, the return of the th stock in the
th time period is a function of the excess
return on the market index over the risk-free rate, the difference in return between a large-
capitalization equity portfolio and a small-cap portfolio, and the difference in return between a high and
a low book-to-market equity portfolio.
All four models use the residual term ɸ , as measure of risk-adjusted abnormal performance.
Nevertheless, only one of the models, the second, relies exactly on the theoretical specifications of the
Sharpe-Linter capital asset pricing model.
In each of the empirical studies discussed, we shall mention the empirical technique by name for the
reason that the market model and the multifactor model are not subject to Roll͛s critique, whereas the
CAPM and the empirical market line are. Thus residual analysis that employs the CAPM or the empirical
market line may be subject to criticism.
  

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 9
  h')
Market efficiency requires that security prices instantaneously and fully reflect all accessible relevant
information. rut what information is relevant? And how fast do security prices really react to new
information? The answers to these questions are of particular interest to corporate officers who report
the performance of their firm to the public; to the accounting profession, which audits these reports;
and to the Securities and Exchange Commission, which regulates securities information (For instance,
Capital Markets and Securities Authority in Tanzania (CMSA)).
The market value of assets is the present value of their cash flow discounted at the appropriate risk-
adjusted rate. Investors should care only about the cash flow implications of various corporate
decisions. Nevertheless, corporations report accounting definitions, not cash flow, and frequently the
two are not related. Does an efficient market look at the effect of managerial decisions on earnings per
share (EPS) on cash flow? This is not an unimportant question, for the reason that frequently managers
are observed to maximize EPS rather than cash flow for the reason that they believe that the market
value of the company depends on reported EPS, when in fact it does not.
$60hh
  h
h hh   

 
Revenue 100 100
Cost of goods sold 90 25 Fourth item 90 LIFO
Operating income 10 75 Third item 60
Taxes at 40 percent 4 30 Second item 40
Net income 6 45 First item 25 FIFO
EPS (100 shares) .06 .45
Cash flow per share .96 .70
Inventory accounting provides a good example of a situation where managerial decisions have opposite
effects on EPS and cash flow. During an inflationary economy the cost of producing the most recent
inventory continues to rise. On the books, inventory is recorded at cost, so that in the example given in
Table 3.1 the fourth item added to the inventory costs more to produce than the first. If management
selects to use first-in, first-out (FIFO) accounting, it will record a cost of goods sold of TZS 25 against a
revenue of TZS100 when an item is sold from inventory. This result in and EPS of TZS0.45. On the other
hand, if LIFO (last-in, first-out) is used, EPS is TZS0.06. The impact of the two accounting treatments on
cash flow is in exactly the opposite direction. For the reason that the goods were manufactured in past
time periods, the actual costs of production are sunk costs and irrelevant to current decision making.
Hence, current cash flows are revenues less taxes. The cost of goods sold is a noncash charge. Hence,
with FIFO, cash flow per share is TZS0.70, whereas with LIFO it is TZS0.96. LIFO provides more cash flow
for the reason that taxes are lower.
If investors really value cash flow and not EPS, we should expect to see stock prices rise when firms
announce a switch from FIFO to LIFO accounting during inflationary periods. Sunder (1973, 1975)
collected a sample of 110 firms that switched from FIFO to LIFO, between 1946 and 1966 and 22 firms
that switched from LIFO to FIFO. His procedure was to look at the pattern of cumulative average
residuals from the CAPM. A residual return is the difference between the actual return and the return
estimated by the model

           h  
The usual technique is to estimate   over an interval surrounding the economic event of interest.
Taking monthly data, Sunder used all observations of returns except for those occurring plus or minus 12

months around the announcement of the inventory accounting change. He then used the estimated 

, the actual risk-free rate, and the actual market return during the 24-month period around the
announcement date to predict the anticipated return. Differences between estimated and actual
returns were then averaged across all companies for each month. The average abnormal return in a
given month is
 `
|
 
`
Þ
 |


where
N M the number of companies.
The cumulative average return (CAR) is the sum of average abnormal returns over all months from the
start of the data up to an including the current month, T:

  Þ 
 |
where
T M the total number of months being summed (TM1,2, ͙, M)
M M the total number of months in the sample.
If there were no abnormal change in the value of the firm associated with the switch from FIFO to LIFO,
we should observe no pattern in the residuals. They would fluctuate around zero and on the average
would equal zero. In other words, we would have a fair game. Assuming that risk does not change
during the 24-month period, the cumulative announcement of the accounting change. This is consistent
with the fact that shareholders actually value cash flow, not EPS. Nevertheless, it does not necessarily
mean that a switch to LIFO causes higher value. Almost all studies of this type, which focus on a
particular phenomenon, suffer from what has come to be known as postselection bias. In this case, firms
may decide to switch to LIFO for the reason that they are already doing well, and their value may have
risen for that reason, not for the reason that of the switch in accounting method. Hence, there are two
explanations for the big run-up prior to the announcement of a switch from FIFO to LIFO. One is that
firms that were doing well were more likely to switch in spite of the lower earnings effect. This
interpretation implies higher than anticipated free cash flow (FCF), Cash flow matters. Alternatively, it
could be that news of the decision leaked out via the rumor mill, and the market reached to higher
anticipated FCF before the announcement. Either way, since FCF is higher, the evidence supports FCF
versus earnings as the variable of interest to the market. Either way, Sunder͛s results are inconsistent
with the fact that shareholders look only at changes in EPS in order to value common stock. He finds no
evidence that the switch to LIFO lowered value even though it did lower EPS.
Ricks (1982) studied a set of 354 NYSE-and AMEX-listed firms that switched to LIFO in 1974. He
computed their earnings ͞as if͟ they never switched and found that the firms that switched to LIFO has
an average 47 percent increase in their as-if earnings, whereas a matched sample of no change firms
had a 2 percent decrease. Ricks also found that the abnormal returns of the switching firms were
significantly lower than the matched sample of no change firms. These results are inconsistent with
those reported by Sunder.
The studies above indicate that investors in efficient markets attempt to evaluate news about the effect
of managerial decisions on cash flowsʹnot on EPS. The empirical studies of Sunder [1973, 1975] provide
evidence of what is meant by relevant accounting information. ry relevant we mean any information
about the anticipated distribution of future cash flows. Next, a study by rall and rrown (1968) provides
some evidence about the speed of adjustment as well as the information context of annual reports.
Earnings data and cash flows are usually highly correlated. The examples discussed above merely serve
to point out some situations where they are not related and hence allow empiricists to distinguish
between the two. rall and rrown used monthly data for a sample of 261 firms between 1946 and 1956
to evaluate the usefulness of information in annual reports. First, they separated the sample into
companies that had earnings that were either higher or lower than those predicted by a naïve time
series model. Their model for the change in earnings was
 
"  È
  È   (3.3)
Where
ѐ`O M the change in earnings per share for the th firm,
ѐ M the change in the average EPS for all firms (other than firm ) in the market.
Q   È|
Next, this regression was used to explain next year͛s change in earnings,  "
 `
Q  



 
| (3.4)
  
|

where
 

,
M coefficients estimated from time-series fits of eq. (3.2) to the data,
 È| M the actual change in market average EPS during the ( +1)th time period.
Finally, estimated changes were compared with actual earnings changes. If the actual change was
greater than estimated, the company was put into a portfolio where returns were anticipated to be
positive, and vice versa.
It is quite evident that when earnings are higher than predicted, returns are abnormally high.
Furthermore, returns appear to adjust gradually until, by the time of the annual report, almost all the
adjustment has occurred. Most of the information contained in the annual report is anticipated by the
market before the annual report is released. In fact, anticipation is so accurate that the actual income
number does not appear to cause any unusual jumps in the API in the announcement month. Most of
the content of the annual report (about 85 percent to 90 percent) is captured by more timely sources of
information. Apparently market prices adjust continuously to new information as it becomes publicly
accessible throughout the year. The annual report has little new information to add.
These results suggest that prices in the marketplace continuously adjust in an unbiased manner to new
information. Two implication for chief financial officers are (1) significant new information, which will
affect the future cash flows of the firm, should be announced as soon as it becomes accessible so that
shareholders can use it without the (presumably greater) expense of discovering it from alternative
sources, and (2) it probably does not make any difference whether cash flows are reported in the
balance sheet, the income statement, or the footnotes ʹ the market can evaluate the news as long as it
is publicly accessible, whatever form it may take.
ã*""h¢Ccã "
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"

  

  
The rall and rrown study raised the question of whether or not annual reports contain any new
information. Studies by Aharony and Swary (1980), Joy, Litzenberger, and McEnally (1977), and Watts
(1978) have focused on quarterly earnings reports, where information revealed to the market is
(perhaps) more timely than annual reports. They typically use a time-series model to predict quarterly
earnings, then form two portfolios of equal risk, one consisting of firms and short in the lower than
anticipated earnings firms and short in the lower than portfolio, which is long in the higher than
anticipated earnings firms and short in the lower than anticipated earnings firms, is a zero-beta portfolio
that (in perfect markets) requires no investment. It is an arbitrage portfolio and should have zero
anticipated return. Watts (1978) finds a statistically significant return in the quarter of the
announcementʹa clear indication that quarterly earnings reports contain new information.
Nevertheless, he also finds a statistically significant return in the following quarter and concludes that
͞the existence of those abnormal returns is evidence that the market is inefficient.͟
Quarterly earnings reports are sometimes followed by announcements of dividend changes, which also
affect the stock price. To study this problem, Aharony and Swary (1980) examine all dividend and
earnings announcements within the same quarter that are at least 11 trading days apart. They conclude
that both quarterly earnings announcements and dividend change announcements have significant
effects on the stock price. rut more significantly they find no evidence market inefficiency when the two
types of announcement effects are separated. They used daily data and Watts (1978) used quarterly
data, so we cannont be sure that the conclusions of the two studies regarding market inefficiency are
inconsistent. All we can say is that unanticipated changes in quarterly dividends and in quarterly
earnings both have significant effects on the value of the firm and that more research needs to be done
on possible market inefficiencies following the announcement of unanticipated earnings changes.
Using intraday records of all transactions for the common stock returns of 96 (large) firms, Patell and
Wolfson (1984) were able to estimate the speed of market reaction to disclosures of dividend and
earnings information. In a simple trading rule, they bought (sold short) stocks whose dividend and
earnings announcements exceeded (fell below) what had been forecast by Value Line Investor Service.
The initial price reactions to earnings and dividend change announcements begin with the first pair of
price changes following the appearance of the news release on the rroad Tape monitors. Although
there was a hint of some activity in the hour or two preceding the rroad Tape news release, by far the
largest portion of the price response occurs in the first 5 to 15 minutes after the disclosure. Thus, as per
Patell and Wolfson, the market reacts to unanticipated changes in earnings and dividends, and it reacts
very quickly.
r
 
During a typical day for an actively traded security on a major stock exchange, thousands of shares will
be traded, usually in round lots ranging between one hundred and several hundred shares.
Nevertheless, occasionally a large block, say 10,000 shares or more, is brought to the floor for trading.
The behavior of the marketplace during the time interval around the trading of a large block provides a
͞laboratory͟ where the following questions can be investigated:
(1) Does the block trade disrupt the market?
(2) If the stock price falls when the block is sold, is the fall a liquidity effect, an information effect, or
both?
(3) Can anyone earn abnormal returns from the fall in price?
(4) How fast does the market adjust to the effects of a block trade?
In perfect (rather than efficient) capital markets, securities of equal risk are perfect substitutes for each
other. For the reason that all individuals are assumed to possess the same information and for the
reason that markets are assumed to be frictionless, the number of shares traded in a given security
should have no effect on its price. If markets are less than perfect, the sale of a large block may have
two effects. First, if it is believed to carry with it some new information about the security, the price will
change (permanently) to reflect the new information. Second, if buyers must incur extra costs when
they accept the block, there may be a (temporary) decline in price to reflect what has been in various
articles described as a price pressure, or distribution effect, or liquidity premium. For instance, if the sale
of a large block has both effects, we may expect the price to fall from the price before the trade (ʹT) to
the block price (rP) at the time of the block trade (rT), then to recover quickly from any price pressure
effect by the time of the next trade (+T) but to remain at a permanently lower level, which reflects the
impact of new information on the value of the security.
Scholes (1972) and Kraus and Stoll (1972) provided the first empirical evidence about the price effects of
block trading. Scholes used daily returns data to analyze 345 secondary distributions between July 1961
and December 1965. Secondary distributions, unlike primary distributions, are not initiated by the
company but by shareholders who will receive the proceeds of the sale. The distributions are usually
underwritten by an investment banking group that buys the entire block from the seller. The shares are
then sold on a subscription basis after normal trading hours. The subscriber pays only the subscription
price and not stock exchange or brokerage commissions.
The data accessible to Kraus and Stoll (1972) pertains to open market block trades. They examined price
effects for all block trades of 10,000 shares or more carried out on the NYSE between July 1, 1968, and
September 30, 1969. They had prices for the close of day before the block trade, the price immediately
prior to the transaction, the block price, and the closing price the day of the block trade. Abnormal
performance indices based on daily data were consistent with Scholes͛s results. More interesting were
intraday price effects. There is clear evidence of a price pressure or distribution effect. The stock price
recovers substantially from the block price by the end of the trading day. For instance, a stock that sold
for TZS50.00 before the block transaction would have a block price of TZS49.43, but by the end of the
day the price would have recorded to TZS49.79.
The Scholes and Kraus-Stoll studies find evidence of a permanent price decline that is measured by price
drops from the closing price the day before the block trade to the closing price the day of the block
transaction. These negative returns seem to persist for at least a month after the block trade. In
addition, Kraus and Stoll found evidence of temporary intraday price pressure effects. The implications
of these findings are discussed by Dann, Mayers, and Raab (1977), who collected continuous
transactions data during the day of a block trade for a sample of 298 blocks between July 1968 and
December 1969. The open-to-block price change is at least 4.56 percent for block with purchases of
TZS100,000 or more could have earned a net annualized rate of return of 203 percent for the 173 blocks
that activated the filter rule. Of course, this represents the maximum realizable rate of return.
Nevertheless, it is clear that even after adjusting for risk, transaction costs, and taxes, it is possible to
earn rates of return in excess of what any existing theory would call ͞normal.͟ This may be interpreted
as evidence that capital markets are inefficient in their strong form. Individuals who are notified of the
pending block trade and who can participate at the block price before the information becomes publicly
accessible do in fact appear to earn excess profits.
Nevertheless, Dann, Mayers, and Raab caution us that we may not properly understand all the costs that
a buyer faces in a block trade. One possibility is that the specialist (or anyone else) normally holds an
optimal utility-maximizing portfolio. In order to accept part of a block trade, which forces the specialist
away from the portfolio, he or she will charge a premium rate of return. In this way, what appear to be
abnormal returns may actually be fair, competitively determined fees for a service renderedʹthe service
of providing liquidity to a seller.
To date, the empirical research into the phenomenon of price changes around a block trade shows that
block trades do not disrupt markets and that markets are efficient in the sense that they very quickly
(less than 15 minutes) fully reflect all publicly accessible information. There is evidence of both a
permanent effect and a (very) temporary liquidity or price pressure effect. The market is efficient in its
semistrong form, but the fact that abnormal returns are earned by individuals who participate at the
block price may indicate strong-form inefficiency.
"C"hã.h "hh";
A direct test of strong-form efficiency is whether or not insiders with access to information that is not
publicly accessible can outperform the market. Jaffe (1974) collected data on insider trading from the
Official Summary of Security Transactions and Holdings, published by the Securities and Exchange
Commission. He then defined an intensive trading month as one during which there were at least three
more insiders selling than buying, or vice versa. If a stock was intensively traded during a given month, it
was included in an intensive-trading portfolio. Using the empirical market line, Jaffe then calculated
cumulative average residuals. If the stock had intensive selling, its residual (which would presumably be
negative) was multiplied by ʹ 1 and added to the portfolio returns, and conversely for intensive buying.
For 861 observations during the 1960s, the residuals rose approximately 5 percent in eight months
following the intensive-trading event, with 3 percent of the rise occurring in the last six months. These
returns are statistically significant and are greater than transactions costs. A sample of insider trading
during the 1950s produces similar results. These findings suggest that insiders do earn abnormal returns
and that the strong-form hypothesis of market efficiency does not hold.
A study by Finnerty (1976) corroborates Haffe͛s conclusions. The major difference is that the Finnerty
data sample was not restricted to an intensive trading group. ry testing the entire population of
insiders, the empirical findings allow an evaluation of the ͞average͟ insider returns. The data include
over 30,000 individual insider transactions between January 1969 and December 1972. Abnormal
returns computed from the market model indicated that insiders are able to ͞beat the market͟ on a risk-
adjusted basis, both when selling and when buying.
A study by Givoly and Palmon (1985) correlates insider trading with subsequent news announcements
to see if insiders trade in anticipation of news releases. The surprising result s that there is no
relationship between insider trading and news events. Although insider͛s transactions are associated
with a strong price movement in the direction of the trade during the month following the trade, these
price movements occur independently of subsequent publication of news. This leads to conjecture that
outside investors accept (blindly) the superior knowledge and follow in the footsteps of insiders.
 "


"


ã
 
The design and interpretation of empirical studies of market efficiency is a tricky business. This brief
selection lists the common pitfalls. Unless research is carefully conducted, results that indicate possible
market inefficiencies may simply be faulty research.
1. r   
 !


 
 : Remember that any test of market efficiency is a joint test
of the model that defines ͞normal͟ returns. If the model is misspecified, then it will not estimate
the correct normal returns, and the so-called abnormal returns that result are not evidence of
market inefficiencyʹonly a bad model.
2. ã    It is always possible, if one tries long enough, to find a model that seems
to beat the market during a test period. Nevertheless, the acid test of whether there is a market
inefficiency is to test the model on a different holdout sample period (or periods).
3. ã 
 
  : A portfolio of stocks that split will always show positive abnormal returns
prior to the split announcement date. Why? For the reason that only stocks whose prices have
risen will decide to split. The very fact that one chooses to study stock splits means that the
presplit characteristics of the sample stocks are abnormal. Modeling their behavior relative to
the market presplit and expecting their postsplit behavior to be similar is a heroic assumption
that is usually wrong.
4. ã


  : If we study the behavior of mutual funds by gathering a list of funds that exist
today, then collect data about their historical performance for analysis, we are designing
survivorship bias into our research. Why? For the reason that we are looking at only those funds
that survived up to today. To avoid survivorship bias we should collect a sample of all funds that
existed on a given date in the past, and then collect data about their performance from that
date forward. ry so doing we will capture all of the funds that ceased to exist between then and
now. They probably have lower excess returns, and failure to include them in our sample implies
upward-biased results.
5. r   
  
  As Fama points out, the calculation of geometric returns over a long
period of time can overstate performance. For instance, suppose that an abnormal return of 10
percent is recorded in year 1 on a test portfolio and then compounded, doubling over an
additional four years. The cumulative return would be (1.1)(2.0)M2.2. A benchmark portfolio
would earn no abnormal return the first year and would also double over the following four
years with a cumulative return of (1.0)(2.0) M 2.0. If we were to take the difference between the
two, we would conclude that the test portfolio earned an abnormal return of 20 percent over
the four years following year 1. This false conclusion can be avoided by measuring cumulative
abnormal return as the ratio of geometric returns on the test portfolio to the geometric returns
on the benchmark portfolio, for instance, [(1.1)(2.0)/(1.0)(2.0)ʹ1]M10 percent. This approach
provides the correct conclusion that 10 percent abnormal return was earned in year 1 and no
abnormal return thereafter.
6.      
 

 The economic interpretation of market inefficiency
depends on value weightings of outcomes. Often equally weighted abnormal returns are
 reported with the average being driven by small firms. The researcher then concludes the
market is inefficient when in fact only the pricing of small illiquid stocks is inefficient.
7. h 

  

   
  
  many studies conclude
that the market is inefficient on a statistical basis without actually going the next step. To be
economically significant, a trading rule must show arbitrage profits after transaction costs that
include paying half of the bid-ask spread, brokerage fees, and net of any price pressure effects.
A market is inefficient only if there is both statistical and economic proof of inefficiency.
8. R
 
 !
    
   
 In practice, arbitrage
opportunities do not appear every day. For instance, transactions involving very large blocks
may offer arbitrage profits, but they do not happen frequently. For the market to be inefficient,
the frequency of opportunities must be high enough to allow economically significant arbitrage
returns.
ã!ã* ã
Why do stocks split, and what effect, if any, do splits have on shareholder wealth? The best-known study
of stock splits was conducted by Fama, Fisher, Jensen, and Roll (1969). Cumulative average residuals
were calculated from the simple market model, using monthly data for an interval of 60 months around
the split ex date for 940 splits between January 1927 and December 1959. It plots the cumulative
average return for the stock split sample. Positive abnormal returns are observed before the split but
not afterward. This would seem to indicate that splits are the cause of the abnormal returns. rut such a
conclusion has no economic logic to it. The run up in the cumulative average returns prior to the stock
split can be explained by selection bias. Stocks split for the reason that their price has increased prior to
the split date. Consequently, it should hardly be surprising that when we select a sample of split-up
stocks, we observe that they have positive abnormal performance prior to the split date. Selection bias
occurs for the reason that we are studying a selected data set of stocks that have been observed to split.
Fama et at. (1969) speculated that stock splits might be interpreted by investors as a message about
future changes in the firm͛s anticipated cash flows. Specifically, they hypothesized that stock splits might
be interpreted as a message about dividend increases, which in turn imply that managers of the firm
feel confident that it can maintain a permanently higher level of cash flows. To test this hypothesis the
sample was divided into those firms that increased their dividends beyond the average for the market in
the interval following the split and those that paid out lower dividends. The results reveal that stocks in
the dividend ͞increased͟ class have slightly positive returns following the split. This is consistent with
the hypothesis that splits are interpreted as messages about dividend increases. Of course, a dividend
increase does not always follow a split. Therefore the slightly positive abnormal return for the dividend-
increase group reflects small price adjustments that occur when the market is absolutely sure of the
increase. On the other hand, the cumulative average residuals of split-up stocks with prior dividend
performance decline until about a year after the split, by which time it must be very clear that the
anticipated dividend increase in not forthcoming. When we combine the results for the dividend
increases and decreases, these results are consistent with the hypothesis that on the average the
market makes unbiased dividend forecasts for split-up securities and these forecasts are fully reflected
in the price of the security by the end of the split month.
A study by Grinblatt, Masulis, and Titman (1984) used daily data and looked at shareholder returns on
the split announcement date as well as the split ex date. They examined a special subsample of splits
where no other announcements were made in the three-day period around the split announcement and
where no cash dividends had been declared in the previous three years. For this sample of 125 ͞pure͟
stock splits they found a statistically significant announcement return of 3.44 percent. They too
interpret stock split announcements as favorable signs about the firm͛s future cash flows. Surprisingly,
they also find statistically significant returns (for their sample of 1,360 stock splits) on the ex date. At
that time there was no explanation for this result, and it is inconsistent with the earlier Fama et al. study
that used monthly returns data.
In the same study, Grinblatt, Masulis, and Titman (1984) confirm earlier work on stock dividends by
Foster and Vickrey (1978) and Woolridge (1983a, 1983b). The announcement effects for stock dividends
are large, 4.90 percent for a sample of 382 stock dividends and 5.89 percent for a smaller sample of 84
stock dividends with no other announcements in a three-day period around the stock dividend
announcement. One possible reason for the announcement effect of a stock dividend is that retained
earnings must be reduced by the Tanzanian Shilling amount of the stock dividend. Only those companies
that are confident they will not run afoul of debt restrictions that require minimum levels of retained
earnings will willingly announce a stock dividend. Another reason is that convertible debt is not
protected against dilution caused by stock dividends. As with stock splits, there was a significant positive
return on the stock dividend ex date (and the day before). No explanation is offered for why the ex date
effect is observed.
The results of Fama et al. (1969) ate consistent with the semistrong for, of market efficiency. Prices
appear to fully reflect information about anticipated cash flows. The split per se has no effect on
shareholder wealth. Rather, it merely serves as a message about the future prospects of the firm. Thus
splits have benefits as signaling devices. There seems to be no way to use a split to increase one͛s
anticipated returns, unless, of course, inside information concerning the split or subsequent dividend
behavior is accessible.
One often hears that stocks split for the reason that there is an ͞optimal͟ price range for common
stocks. Moving the security price into this range makes the market for trading in the security ͞wider͟ or
͞deeper͟; therefore there is more trading liquidity. Copeland (1979) reports that contrary to the above
argument, market liquidity is actually lower following a stock split. Trading volume is above argument,
market liquidity is actually lower following a stock split. Trading volume is proportionately lower than its
presplit level, brokerage revenues (a major portion of transaction costs) are proportionately higher, and
bid-ask spreads are higher as a percentage of the bid price.
Taken together, these empirical results point to lower postsplit liquidity. Therefore we can say that the
market for split-up securities has lower operational efficiency relative to its presplit level. Ohlson and
Penman (1985) report that the postsplit return standard deviation for split-up stocks exceeds the
presplit return standard deviation by an average of 30 percent. Lower liquidity and higher return
variance are both costs of splitting.
rrennan and Copeland (1988) provide a costly signaling theory explanation for stock splits and show
that it is consistent with the data. The intuition can be explained as follows. Suppose that managers
know the future prospects of their firm better than the market does. Furthermore, assume that there
are two firms with a price of TZS60 per share that are alike in every way except that the managers of
firm A know it has a bright future while the managers of firm r except only average performance.
Managers of both firms know that if they decide to announce a split, their shareholders will suffer from
the higher transaction cost documented by Copeland (1979). Nevertheless, the successful firm A will
bear these costs only temporarily (for the reason that its managers have positive information about its
future), while firm r will bear them indefinitely. Therefore firm A will signal its bright future with a stock
split, and the signal will not be mimicked by firm r. Costly signaling creates a separating equilibrium. As
a result, A͛s price will rise at the time of the announcement so as to reflect the present value of its
future prospects. Furthermore, the lower the target price to which the firm splits, the greater
confidence management has, and the larger will be the announcement residual. Empirical results by
rrennan and Copeland (1987) confirm this prediction.
Dharan and Ilenberry (1995) and Rankine, and Stice (1996) have reported roughly 7 percent positive
abnormal returns in the year after the split ex date. If valid, these results would be inconsistent with
semistrong-form market efficiency. Fama (1998) notes that these studies use buy-and-hold returns in
the following way. Suppose that the test group of firms record a 10 percent abnormal return during the
announcement year and the benchmark portfolio records a 0 percent abnormal return. Then assume
that both portfolios record a cumulative 100 percent buy-and-hold return (rAHR) over the next four
years. The rAHR for the test group will be 1.1×2.0M2.20 and the rAHR for the benchmark group will be
1.0 × 2.0, leading to the mistaken conclusion that an abnormal return of 20 percent had been earned
over the five-year period including the year of the announcement. One way to correct this problem is to
take the ratios of the cumulative returns rather than their difference. In this case we are back to a ratio
of 1.1, that is, to a 10 percent abnormal return (in the announcement year)
 9
  
ã

Hundreds of investment advisory services sell advice that predicts the performance of various types of
assets. Perhaps the largest is the Value Line Investor Survey. Employing over 200 people, it ranks around
1,700 securities each week. Securities are ranked 1 to 5 (with 1 being highest), based on their
anticipated price performance relative to the other stocks covered in the survey. Security rankings result
from a complex filter rule that utilizes four criteria: (1) the earnings and price rank of each security
relative to all others, (2) a price momentum factor, (3) year-to-year relative changes in quarterly
earnings, and (4) an earnings ͞surprise͟ factor. Roughly 53 percent of the securities are ranked third, 18
percent are ranked second or fourth, and 6 percent are ranked first or fifth.
The value line predictions have been the subject of many academic studies for the reason that they
represent a clear attempt to use historical date in a complex computerized filter rule to try to predict
future performance.
rlack (1971) performed the first systematic study utilizing Jensen͛s abnormal performance measure,
which will be given later in eq. (3.7). rlack͛s results indicate statistically significant abnormal
performance for equally weighted portfolios formed from stocks ranked 1, 2, 4, and 5 by Value Line and
rebalanced monthly. refore transactions costs, portfolios 1 and 5 had risk-adjusted rates of return of +
10 percent and ʹ10 percent, respectively. Even with round-trip transaction costs of 2 percent, the net
rate of return for a long position in portfolio 1 would still have been positive, thereby indicating
economically significant performance. One problem with these results in the Jensen methodology for
measuring portfolio performance. It has been criticized by Roll (1977, 1978), who argues that any
methodology based on the capital asset pricing model will measure either (1) no abnormal performance
if the market index portfolio is ex post efficient or (2) a meaningless abnormal performance if the index
portfolio is ex post inefficient.
Copeland and Mayers (1982) and Chen, Copeland, and Mayers (1987) measured Value Line portfolio
performance by using a future benchmark technique that avoids selection bias problems associated with
using historic benchmarks as well as the known difficulties of using capital asset pricing model
benchmarks. The future benchmark technique uses the market model fit using data after the test period
where portfolio performance is being measured. The steps in the procedure are:
1. Using the sample from after the test period, calculate the market model equation for the
portfolio being evaluated.
2. Use the parameters of the model as a benchmark for computing the portfolio͛s unanticipated
return during a test period.
3. Repeat the procedure and the test to see whether the mean unanticipated return is significantly
different from zero.
In other words, rather than using a particular (perhaps suspect) model (such as the CAPM) of asset
pricing as a benchmark, estimate the anticipated returns directly from the data. The future benchmark
technique is not without its problems, nevertheless. It assumes that the portfolio characteristics (e.g.,
risk and dividend yield) remain essentially the same throughout the test and benchmark periods.
Copeland and Mayers find considerably less abnormal performance than rlack, who uses the Jensen
methodology. Where rlack reported (roughly) 20 percent per year for an investor who was long on
portfolio 1 and short on portfolio 5, Copeland and Mayers find and annual rate of return of only 6.8
percent. Moreover, only portfolio 5 had statistically significant returns. Nevertheless, any significant
performance is a potential violation of semistrong market efficiency. Thus Value Line remains an
enigma.
Stickel (1985) uses the future benchmark methodology to assess the abnormal presentation resulting
from changes in Value Line rankings. He finds statistically noteworthy returns for reclassifications from
rank 2 to rank 1 that are three times as large as the returns from reclassifications from 1 to 2.
Upgradings from 5 to 4 were not associated with significant abnormal returns. He concludes that the
market reacts to Value Line reclassifications as news events and that the price adjustment is larger for
smaller firms.
ã 
 ã 

   
Lakonishok and Vermaelon (1990), Ikenberry, Laknonishok, and Vermaelen (1995), and Mitchell and
Stafford (1977) all find abnormal returns from a trading rule where one purchases a stock on the day
following the announcement of a planned self-tender or open-market repurchases a stock on the day
following the announcement of a planned self-tender or open-market repurchase plan. For instance,
Mitchell and Stafford report three-year buy-and-hold returns of 9 percent for 475 self-tenders during
the 1960-1993 time period, after controlling for size and for book-to-market. They also report a 19
percent abnormal return for a portfolio of 2,542 open-market repurchase plants. These abnormal
returns are statistically and economically significant and would be consistent with market inefficiency.
Nevertheless, most of the abnormal returns vanish when they use a three-factor benchmark that
includes as independent variables (1) the difference between the return on the market portfolio and the
risk-free rate, (2) the difference between the returns on a small-cap portfolio minus a large-cap
portfolio, and (3) the difference between returns on a high book-to-market and a low book-to-market
portfolio. Furthermore, the abnormal returns disappear completely if the portfolio of repurchases is
value weighted rather than equally weighted. The lesson learned from these results is that
measurement of abnormal returns is extremely sensitive to apparently minor changes in technique.
ã" ã.h ¢ ¢ "ãã#" 
h  
Mutual funds allege that they can provide two types of service to their clients. First, they minimize the
amounts of unsystematic risk an investor must face. This is done through efficient diversification in the
face of transaction costs. Second, they may be able to use their professional expertise to earn abnormal
returns through successful prediction of security prices. This second claim is contradictory to the
semistrong form of capital market efficiency unless, for some reason, mutual fund managers can
consistently obtain information that is not publicly accessible.
A number of studies have focused their attention on the performance of mutual funds. A partial list
includes Friend and Vickers (1965), Sharpe (1996), Treynor (1965), Farrar (1962), Friend, rlume, and
Crockett (1970), Jensen (1968), Mains (1977), Henricksson (1984), and Grinblatt and Titman (1989).
Various performance measures are used. Among them are
 
 
ã
  
(3.5)
Ä
    
@ 
  (3.6)
h 

Abnormal performance M
   
  
  
   (3.7)
Where
á M the return of the th mutual fund,
á M the return on a risk-free asset (usually Treasury bills),
ʍj M the estimated standard deviation of return on the th mutual fund,

 M the estimated systematic risk of the th mutual fund
Of these, the abnormal performance measure of Eq. (3.7) makes use of the CAPM. It was developed by
Jensen (1968), who used it to test the abnormal performance of 115 mutual funds, using annual data
between 1955 and 1964. If the performance index, ɲ, is positive, then after adjusting for risk and for
movements in the market index, the abnormal performance of a portfolio is also positive. The average ɲ
for returns measured net of costs (such as research costs, management fees, and brokerage
commissions) was ʹ1.1 percent per year over the 10 year period. This suggests that on the average the
funds were not able to forecast future security prices well enough to cover their expenses. When
returns were measured gross of expenses (except brokerage commissions), the average ɲ was ʹ.4
percent per year. Apparently the gross returns were not sufficient to recoup even brokerage
commissions.
In sum, Jensen͛s study of mutual funds provides evidence that the 115 mutual funds, on the average,
were not able to predict security prices well enough to outperform a buy-and-hold strategy. In addition,
there was very little evidence that any individual fund was able to do better than what might be
anticipated from mere random chance. These conclusions held even when fund returns were measured
gross of management expenses and brokerage costs. Results obtained are consistent with the
hypothesis of capital market efficiency in its semistrong form, for the reason that we may assume that,
at the very least, mutual fund managers have access to publicly accessible information. Nevertheless,
they do not necessarily imply that mutual funds will not be held by rational investors. On the average
the funds do an excellent job of diversification. This may by itself be a socially desirable service to
investors.
Mains (1977) reexamined the issue of mutual fund performance. He criticized Jensen͛s work on two
accounts. First, the rates of return were underestimated for the reason that dividends were assumed to
be reinvested at year͛s end rather than during the quarter they were received and for the reason that
when expenses were added back to obtain gross returns, they were added back at year͛s end instead of
continuously throughout the year. ry using monthly data instead of annual data, Mains is able to better
estimate both net and gross returns. Second, Jensen assumed that mutual fund betas were stationary

over long periods of time; note that  has not time subscript in Eq. (3.7). Using monthly data, Mains

observes lower estimates of  and argues that Jensen͛s estimates of risk were too high.
The abnormal performance results calculated for a sample of 70 mutual funds indicate that as a groups
the mutual funds has neutral risk-adjusted performance on a net return basis. On a gross return basis
(i.e., before operating expenses and transaction costs), 80 percent of the funds sampled performed
positively. This suggests that mutual funds are able to outperform the market well enough to earn back
their operating expenses. It is also consistent with the theory of efficient markets given costly
information. As you saw in the previous unit that the theoretical work of Cornell and Roll (1981) and
Grossman (1980) predicts a market equilibrium where investors who utilize costly information will have
higher gross rates of return than their uninformed competitors. rut for the reason that information is
costly, the equilibrium net rates of return for informed and uninformed investors will be the same. This
is just what Main͛s work shows. Mutual funds͛ gross rates of return are greater than the rate on a
randomly selected portfolio of equivalent risk, but when costs (transaction costs and management fees)
are subtracted, the net performance of mutual funds is the same as that for a naïve investment strategy.
There have been several studies of mutual fund performance that have seemingly found evidence of
market inefficiency for the reason that there is persistence, or autocorrelation, in the abnormal
performance of mutual funds over time. Stickel (1992) and Grinblatt and Titman (1992) approach the
question in different ways in the same issue of the Journal of Finance. Stickel compares the accuracy of
analyst recommendations for two groups, an award-winning All-American Research Team, selected by
the Institutional Investor magazine, and all others. The abnormal returns for the first 11 days following
large upward forecast revisions indicates that the All-American portfolio has a 0.21 percent greater
average impact on security prices than the non-All-Americans, after controlling for the size of the firm
and the magnitude of the revision. There is no difference between the two groups when there are
downward revisions. Grinblatt and Titman (1992) study the persistence of mutual fund performance.
They find that, after controlling for firm size, dividend yield, past returns, interest rate sensitivity, beta,
and skewness, there is statistically significant persistence in returns over time and evidence that mutual
fund managers can earn abnormal returns. Carhart (1977) reexamines the issue using a sample that is
free of survivorship or selection bias, and demonstrates that the persistence in returns is completely
explained by common factors in stock returns and investment expenses. His results do not provide
evidence of the existence of skilled or informed mutual fund portfolio managers.
*
 h  
Dual purpose funds are companies whose only assets are the securities of other companies.
Nevertheless, unlike open-end funds, closed-end dual-purpose funds neither issue new shares nor
redeem outstanding ones. Investors who wish to own shares in a closed-end fund must purchase fund
shares on the open market. The shares are divided into two types, both of which have claim on the same
underlying assets. The capital shares of a dual fund pay no dividends and are redeemable at net asset
value at the (predetermined) maturity date of the fund. The income shares receive any dividends or
income that the fund may earn, subject to a stated minimum cumulative dividend, and are redeemed at
a fixed price at the fund͛s maturity date. Dual funds were established on the premise that some
investors may wish to own a security providing only income, whereas other investors may desire only
potential capital gains.
There are two very interesting issues that are raised when one observes the market price of closed-end
shares. First, the market value of the fund͛s capital shares does not equal the net asset value. Most
often, the net asset value per share exceeds the actual price per share of the dual fund. In this case the
dual fund is said to sell at a discount. Given that a speculator (especially a tax-exempt institution) could
buy all of a fund͛s outstanding shares and liquidate the fund for its net asset value, it is a mystery why a
discount (or premium) can persist. The second issue has to do with whether or not risk-adjusted
abnormal rates of return accrue to investors who buy a dual fund when it is selling at a discount, then
hold it for a period of time, possibly to maturity.
Ingresoll (1976) shows that the capital shares of a dual fund are analogous to call options written on the
dividend-paying securities held by the fund. Holders of income shares are entitled to all income
produced by the portfolio plus an amount equal to their initial investment payable when the fund
matures. If S is the value of the fund at maturity and X is the promised payment to income shares, then
capital shareowners receive the maximum of (SʹX) or zero, whichever is larger, at maturity. This payoff
can be written as
MAX [SʹX,0]
and is exactly the same as the payoff to a call option. We know, from option pricing theory, that the
present value of a call option is bounded from below by &'
&
. Nevertheless, dual funds are
characterized by the fact that cash disbursements in the form of dividends and management fees are
made over the life of the fund. If these disbursements are assumed to be continuous, then the present
value of the fund is 
&(, where ɶ is the rate of payment. Ingersoll shows that, given the cash
disbursements, the lower bound on the value of the capital shares must be 
&(& '
&
. The dashed
line, S ʹ X, is the net asset value of the capital shares. When the fund is above a critical level, , the
capital shares will sell at a discount. relow , they sell at premium.
When Ingersoll used the option pricing model to estimate the market value of capital shares, he found
that it tracked actual prices very well in spite of the fact that no tax effects were taken into account. The
data consisted of prices for seven funds on a weekly basis between May 1967 and December 1973.
Furthermore, he simulated a trading rule that bought (sold) capital shares when the option model price
was above (below) the market price and financed the investment by an opposite position in the
securities of the fund and borrowing or lending at a riskless rate. Thus a hedged portfolio was created
that required no investment and that had very low risk. The returns on the hedge portfolio were (almost
always) insignificantly different from zero. This suggests that even though the capital shares may sell for
a discount or premium, they are efficiently priced in a semistrong form sense.
When Ingersoll used the option pricing model to estimate the market value of capital shares, he found
that it tracked actual prices very well in spite of the fact that no tax effects were taken into account. The
data consisted of prices was above (below) the market price and financed the investment by an opposite
position in the securities of the fund and borrowing or lending at a riskless rate. Thus a hedged portfolio
was created that required no investment and that had very low risk. The returns on the hedge portfolio
were (almost always) insignificantly different from zero. This suggests that even though the capital
shares may sell for a discount or premium, they are efficiently priced in a semistrong-form sense.
Thompson (1978) measures the performance of closed-end dual funds by using all three versions of the
empirical models described at the beginning of this chapter. He used monthly data for 23 closed end
funds. The longest-lived fund was in existence from 1940 until 1975 (when the data set ended). A
trading rule purchased shares in each fund that was selling at a discount at the previous years͛ end, then
held the fund and reinvested all distributions until the end of the year. The procedure was repeated for
each year that data existed, and abnormal returns were then calculated for a portfolio based on this
trading strategy. Thompson found that discounted closed-end fund shares tend to outperform the
market, adjusted for risk. ry one performance measure the annual abnormal return (i.e., the return
above the earned by NYSE stocks of equivalent risk) was in excess of 4 percent. It is interesting to note
that a trading strategy that purchased shares of funds selling at a premium would have experienced a ʹ
7.9 percent per year abnormal return, although the results were not statistically significant.
There are several explanations for Thompson͛s results. First, the market may be inefficient, at least for
tax-exempt institutions that could seemingly be able to profit from the above-mentioned trading rule.
Second, so long as taxable investors persist in holding closed-end shares, the gross rates of return before
taxes may have to exceed the market equilibrium rate of return in order to compensate for unrealized
tax liabilities. Third, abnormal return measures based on the capital asset pricing model may be
inappropriate for measuring the performance of closed-end fund capital shares that are call options.
An interesting paper by rrauer (1984) reports on the effects of open-ending 14 closed end funds
between 1960 to 1981. Funds that were open-ended had larger discounts from net asset value (23.6
percent versus 16.2 percent) and lower management fees (.78 percent versus 1.00 percent) than funds
that were not open-ended. Large discounts provide shareholders with greater incentive to open-end
their funds, and lower management fees imply less management resistance. These two variables were
actually able to predict which funds would be open-ended. In addition, rrauer reports that most of the
(large abnormal) returns that resulted from the announcement of open-ending were realized by the end
of the announcement monthʹa result consistent with semistrong-form market efficiency.
The problem of analyzing dual funds is not yet completely resolved. The observed discounts (premia) on
capital shares may be attributable to (1) unrealized capital gains tax liabilities, (2) fund holdings of letter
stock, (3) management and brokerage costs, or (4) the option nature of capital shares. The relative
importance of these factors has not yet been completely resolved. There is no good explanation for why
all funds selling at a discount have not been open-ended. In addition, there remains some questions
about whether or not abnormal returns can be earned by utilizing trading rules based on observed
discounts (premia). Thompson͛s (1978) work suggests that abnormal returns are possible, whereas
Ingersoll (1976) finds no evidence of abnormal returns.


ã

 
If it were possible to reweight away from high-risk stocks during market downturns and toward them
during upturns, it would be possible to outperform a buy-and-hold strategy. Also, timing would be
possible if the market or segments of it were to overreact or under react to the arrival of new
information (e.g., earnings news or macroeconomic indicators). Empirical evidence of timing is difficult
to find for the reason that the decisions of fund managers simultaneously include both the selection of
individual stocks for their own merit as well as reweighting for timing reasons. A few studies,
nevertheless, examine trading rules directly. Graham and Harvey (1996) and Copeland and Copeland
(1999) examine trading rules designed to exploit new information about volatility. Copeland (1999)
examine trading rules designed to exploit new information about volatility. Copeland and Copeland find
that when an index for forward-looking implied volatility, called VIX, increases surprisingly from its
current level, it is possible to earn statistically significant returns by a significant proportion of mutual
fund managers reduce their market exposure during periods of increased market volatility. Fleming,
Kirby, and Ostdiek (2001) find that volatility-timing strategies earn economically and statistically
significant returns. These timing anomalies, although statistically significant, are usually small in
magnitude. Nevertheless they represent evidence of semistrong form inefficiency that has not yet been
explained away.
ã  

c 

It is also widely believed that instead of adjusting smoothly, stocks tend to overshoot the equilibrium
price. If so, a strategy that is based on this idea might easily earn significant excess returns. Chopra,
Lakonishok, and Ritter (1992), like Derondt and Thaler (1985) before them, report that stocks that are
extreme losers at time zero outperform those that were extreme winners over the following five years.
The extent of abnormal performance ranges from 6.5 percent per year using annual data to 9.5 percent
per year using monthly data. After adjusting for size but before adjusting for beta, extreme losers
outperform extreme winners by 9.7 percent per year. In the context of multiple regressions that control
for size, beta, and prior returns, there still remains an economically significant overreaction of 5 percent
per year. Nevertheless, much of this excess return in seasonal, being earned in January, and seems to be
more pronounces among smaller firms. There was no evidence of overreaction among a set of large
market cap firms. Furthermore, rell, Kothari, and Shanken (1995) report that abnormal returns from the
strategy become statistically insignificant when changes in the betas of winners and losers are taken into
account.
ããã"¢ *cDD "ã
Any predictable pattern in asset returns may be exploitable and hence judged as evidence against weak-
form market efficiency. Even if the pattern cannot be employed directly in a trading rule for the reason
that of prohibitive transactions costs, it may enable people who were going to trade anyway to increase
their portfolio returns over what they otherwise may have received without knowledge of the pattern.
Two statistically significant patterns in stock market returns are the weekend effect and the turn-of-the
year effect.
Table 3.2: Summary Statistics for Daily Returns on the S&P 500 Stock Index, 1953-1977
Means, Standard Deviations, and t-Statistics of the Percent Return from the Close of the Previous
Trading Day to the Close of the Day Indicateda
Monday Tuesday Wednesday Thursday Friday
1953-1977 Mean ʹ0.1681 0.0157 0.0967 0.0448 0.0873
Standard- 0.8427 0.7267 0.7483 0.6857 0.6600
deviation
-statistic ʹ6.823c 0.746 4.534c 2.283b 4.599c
Observations 1,170 1,193 1,231 1,221 1,209
a. Returns for periods including a holiday are omitted. These returns are defined as á Mln(t/tʹ1)
b. 5 percent significance level
 c. 0.5 percent significance level
ã
: K. French, ͞Stock Returns and the Weekend Effect,͟ reprinted from the Journal of Financial Economics, March 1980, 58.
 :"
French (1980) studied daily returns on the Standard and Poor͛s composite portfolio of the 500 largest
firms on the New York Stock Exchange over the period 1953 to 1977. Table 3.2 shows the summary
statistics for returns by day of the week. The negative returns on Monday were highly significant. They
were also significantly negative in each of the five-year subperiods that were studied.
An immediate natural reaction to explain this phenomenon is that firms wait until after the close of the
market on Fridays to announce bad news. The trouble is that soon people would expect such behaviour
and discount Friday prices to account for it. In this way negative returns over the weekend would soon
be carried off. Another clarification is that negative proceeds are caused by a general ͞market-closed͟
effect. French eliminated this possibility by showing that for days following holidays, only Tuesday
returns were negative. All other days of the week that followed holidays had positive returns.
At present there is no satisfactory explanation for the weekend effect. It is not directly exploitable by a
trading rule for the reason that transaction costs of even .25 percent eliminate all profits. Nevertheless,
it may be considered a form of market inefficiency for the reason that people who were going to trade
anyway can delay purchases planned for Thursday or Friday until Monday and execute sales scheduled
for Monday on the preceding Friday.
;
" "
Another appealing trend in stock prices is the so-called year-end effect, which has been documented by
Dyl (1973), rranch (1977), Kein (1983), Reinganum (1983), Roll (1983), and Gultekin and Gultekin (1983).
Stock returns decline in December of each year, particularly for small firms and for firms whose price
had already declined during the year. The prices increase during the following January. Roll (1983)
reported that for 18 consecutive years from 1963 to 1980, average returns of small firms have been
better than average returns of large firms on the first trading day of the calendar year. That day͛s
difference in returns between equally weighted indices of AMEX-and NYSE-listed stocks averaged 1.16
percent over the 18 years. The t-statistics of the difference was 8.18.
Again quoting Roll (1983):
To put the turn-of-the-year period into perspective, the annual return differential between equally-
weighted and value-weighted indices of NYSE and AMEX stocks was 9.31 percent for calendar year 1963-
1980 inclusive. Throughout those same years, the average return for the five days of the turn-of-the ʹ
year (last day of December and first five days of January) was 3.45 percent. Thus, about 37 percent of
the annual degree of difference is due to just five trading days, 67 percent of the annual discrepancy is
due to the first twenty trading days of January plus the last day of December.
The most probable cause of the year-end effect is tax selling. At least there is a significant correlation
amid the realized rates of return during the year and the size of the turn-of-the-year price recovery.
Whether or not this occurrence is credulous with a trading rule remains to be seen. Nevertheless, an
individual who is going to transact anyway can benefit by altering his or her timing to buy late in
December and to sell in early January. rhardwaj and rrooks (1992) looked at net returns after
transaction costs and bid-ask spreads for turn-of-the-year trading strategies for 300 NYSE stocks during
the 1982-1986 time period. They bring to a close conclusion that after transactions costs ͞the January
anomaly of low-price stocks outperforming high-price stocks cannot be used to earn abnormal returns.͟

ãc ¢;
To the highest degree (but not all) evidence suggests that capital markets are well-organized and
competent in their weak and semistrong forms, that security prices do the accepted thing to a fair-game
model but not precisely to a random walk for the reason that of small first-order dependencies in prices
and nonstationarities in the primary price distribution over time, and that the strong form of market
efficiency does not hold. Nevertheless, any conclusions about the strong form of market efficiency need
to be experienced by the fact that capital market efficiency must be well thought-out jointly with
competition and efficiency in markets for information. If insiders have monopolistic access to
information, this fact may be considered an inefficiency in the market for information rather than in
capital markets. Filter rules have shown that security prices exhibit no dependencies over time, at least
down to the level of transaction costs. Therefore, the capital markets are allocationally competent up to
the point of operational efficiency. If transaction costs amounted to a greater percentage of value
traded, price dependencies for filter rules greater than 1.5 percent might have been found.
"9":<c"ãã
1. Roll͛s critique of tests of the CAPM shows that if the index portfolio is ex post efficient, it is
mathematically impossible for abnormal returns, as measured by the empirical market line, to
be statistically different from zero. Yet the Ibbotson study on new issues uses the cross-section
empirical market line and finds significant abnormal returns in the month of issue and none in
the following months. Given Roll͛s critique, this should have been impossible. How can the
empirical results be reconciled with the theory?
2. In a study of corporate disclosure by a special committee of the Securities and Exchange
Commission, we find the following statement:
The ͞efficient market hypothesis͟ʹwhich asserts that the current price of a security reflect all
publicly accessible informationʹeven if valid, does not negate the necessity of a mandatory
disclosure system. This theory is concerned with how the market reacts to disclosed information
and is silent as to the optimum amount of information required or whether that optimum
should be achieved on a mandatory or voluntary basis; market forces alone are insufficient to
cause all material information to be disclosed.
Two questions that arise are:
(a) What is the difference between efficient markets for securities and efficient markets for
information?
(b) What criteria define ͞material information͟?
3. Describe in your own words, what does the empirical evidence on block trading tell us about
market efficiency?
4. Which of the following types of information provides a likely opportunity to earn abnormal
returns on the market?
(a) The latest copy of a company͛s annual report.
(b) News coming across the NYSE ticker tape that 100,000 shares of Oracle were just traded in a
single block.
(c) Advance notice that the XYZ Company is going to split its common stock three for one but
not increase dividend payout.
(d) Advance notice that a large new issue of common stock in the ArC Company will be offered
soon.
5. Mr. A has received, over the last three months, a solicitation to purchase a service that claims to
be able to forecast movements in the Dow Jones Industrial index. Normally, he does not believe
in such things, but the service provides evidence of amazing accuracy. In each of the last three
months, it was always right in predicting whether or not the index would move up more than 10
points, stay within a 10-point range or go down by more than 10 points. Would you advise him
to purchase the service? Why or why not?
6. The Sigma Mutual Fund (which is not registered with the SEC) guarantees a 2 percent per month
(24 percent per year) return on your money. You have looked into the matter and found that
they have indeed been able to pay their shareholders the promised return for each of the 18
 months they have been in operation. What implications does this have for capital markets?
Should you invest?
7. Empirical evidence indicates the mutual funds that have abnormal returns in a given year are
successful in attracting abnormally large numbers of new investors the following year. Is this
consistent with capital market efficiency?
8. In each of the following situations, explain the extent to which the empirical results offer
reliable evidence for (or against) market efficiency.
(a) A research study using data for firms continuously listed on the Compustat computer tapes
from 1953 to 1973 finds no evidence of impending bankruptcy cost reflected in stock prices
as a firm͛s debt/equity ratio increases.
(b) One thousand stockbrokers are surveyed via questionnaire; and their stated investment
preferences are classified as per industry groupings. The results can be used to explain rate
of return differences across industries.
(c) A study of the relationships between size of type in the Newspaper headline and size of
price change (in either direction) in the subsequent day͛s stock index reveals a significant
positive correlation. Further, when independent subjects are asked to qualify the headline
news as good, neutral, or bad, the direction of the following day͛s price change (up or down)
is discovered to vary with the quality of news (good or bad).

¢ã"ãc;
#""hh" ¢!"#;*#"ãã"9""h "¢h¢ã! ¢!"ã
c
Since the work by Fama (1965, 1970), the efficient market hypothesis (EMH) has become a central part
of finance theory. The vast body of research done around this concept is evidence of the interest that
the EMH has drawn in both the investment and academic circles. Nevertheless, the bulk of this evidence
is from developed markets in the United States and Europe (Groenewold and Ariff, 1998; Mobarek and
Keasey, 2000). Little is known about the efficiency of emerging markets, especially those in Africa. The
studies available on African stock markets mostly made use of indices data. This is more so in studies
that have included more than one market (e.g., Appiah-Kusi and Menyah, 2003).
The majority of studies relating to market efficiency with respect to African stock markets have been
conducted on the Johannesburg Stock Exchange (JSE). Smith et al. (2002), Smith and Jefferis (2002) and
Magnusson and Wydick (2002), among others, found the JSE to be weak-form efficient. Appiah-Kusi and
Menyah (2003), nevertheless, concluded on the contrary that the JSE is not weak-form efficient for the
period 1990 to 1995, using weekly data.
Appiah-Kusi and Menyah (2003) found the stock markets of rotswana, Ghana and the Ivory Coast not to
be weak-form efficient for the respective periods investigated. The findings for Ghana and rotswana are
consistent with those by Magnusson and Wydick (2002) who found the two markets not to conform to
random walk 3 and random walk 2, respectively. Appiah-Kusi and Menyah (2003) concluded that Kenya,
Zimbabwe, Egypt, Morocco and Mauritius are weak-form efficient2. Kiweu (1991) and Dickinson and
Muragu (1994) reached the same conclusion for Kenya, for the periods 1986 to 1990 and 1979 to 1988,
respectively, while Chiwira (2001) found the Zimbabwe Stock Exchange to be weak-form efficient for the
period 1995 to 1999. Smith et al. (2002) concluded, on the contrary, that Egypt, Morocco and Mauritius
are not weak-form efficient for the periods January 1990 to August 1998 for Morocco and Mauritius,
and January 1993 to August 1998 for Egypt. rundoo (2000) reached the same conclusion for the Stock
Exchange of Mauritius (SEM) for the period 1992 to 1998. Asal (2000) also found the Egyptian Stock
Exchange to be weak-form inefficient for the period 1992 to 1996, although he suggested that it was
moving towards efficiency in 1997.
Studies that have used data on individual stocks used either monthly or weekly data rather than daily
data. The limiting factor, among others, as pointed out by Dickinson and Muragu (1994), has been the
nonavailability of computerised databases. The other argument for using data measured over longer
time intervals is the problem of thin-trading. Increasing the time interval is argued to reduce the
potential biases associated with thin-trading by increasing the probability of having at least one trade in
the interval (Dickinson and Muragu, 1994). The trade, most probably, would not have taken place at the
end of the interval. The result of this is what rowie (1994) referred to as the ͞price age͟ component.
This component of thin-trading, though more critical in long time horizons, is usually ignored.
Although some studies on African stock markets have acknowledged the thin-trading problem, very few
have gone beyond mere acknowledgement of the existence of the problem. The limited studies that
tried to address the thin-trading problem include Asal (2000) on the Egyptian Stock Exchange and
Appiah-Kusi and Menyah (2003) on eleven African stock markets. roth studies used the adjustment
method by Miller, Muthuswany and Whaley (1994) for index returns.
¢9"9":h¢h¢ã! ¢!"ã
 
 
About two-thirds of African stock markets emerged in the late 1980s and early 1990s (Mlambo and
riekpe, 2001; Moss, 2004). The latest arrival is the Douala Stock Exchange in Cameroon, which was
established in 2003, making it the youngest stock market on the African continent. Most of these
markets were formed at the instigation of government to act as vehicles to privatise state-owned
enterprises (Mlambo and riekpe, 2001; Moss, 2004). This is contrary to misconceptions in some circles
that donor agencies, in particular the World rank and International Monetary Fund, are the driving
forces behind the establishment of stock markets in Africa.
African stock exchanges are also the smallest in the world in terms of both number of listed stocks and
market capitalisation (see Table 1). They are also small relative to their economies, with the market
capitalisation of the Nigerian Stock Exchange only representing 8 percent of gross national product
(GNP), while in the case of Zimbabwe, Kenya and Ghana, the market capitalisations ranged from 25
percent to 35 percent of GNP (Kenny and Moss, 1998). The largest African stock market in terms of
market capitalisation is the JSE (Table 1). According to Senbet (2000), the market capitalisation of the
JSE is ten times the combined capitalisation of the rest of Africa͛s stock markets and over 100 times their
average. Of the more than 2 000 firms listed on Africa͛s stock exchanges, the majority are listed on
Egypt͛s Cairo and Alexandria Stock Exchanges (CASE), although only a small percentage of these are
actively traded.



  

   
The majority of stock markets in Africa trade daily, from Monday to Friday (Sunday to Thursday in
Egypt), except for a few such as Ghana4, Tanzania, and Uganda, which, in 2002 were trading three times
a week. Ghana was trading on Monday, Wednesday and Friday, while Tanzania and Uganda were
trading on Tuesday, Wednesday and Thursday (see Table 2). Trading times also vary, ranging from one
hour per trading day in Tanzania to the whole business day from 08h00 to 16h30 in Zimbabwe (see
Table 2). Trading methods on African stock exchanges vary from open-outcry to call-over to electronic
trading systems (Table 2). The Nigerian stock market has replaced the call-over trading system with the
automated trading system (ATS). Clearing, settlement and delivery of transactions on the exchange are
now done electronically by the Central Securities Clearing System (CSCS). Following the closure of the
open outcry trading floor in June 1996, the JSE introduced an order driven, centralised, automated
trading system known as the JSE Equities Trading (JET) system. In May 2002 the JET system was
converted to the Stock Exchange Trading Systems (SETS) used on the London Stock Exchange (LSE). SETS
is a world-class, flexible and robust trading platform that promise improved liquidity and ensure more
efficient functionality. SETS also allows South African based companies access to offshore privileges
without having to move offshore. Other markets that adopted the JSE͛s trading system include Ghana
and the Namibia Stock Exchanges.
Migration from an open outcry to an electronic trading system on the Casablanca Stock Exchange (CSE)
took place between 4 March 1997 and 15 June 1998. All securities quoted on the CSE are now traded on
the electronic trading system. Orders entered by dealers are automatically sorted by price limit and in
chronological order, in the "market order book". On the central market, the less liquid securities are
quoted on a call auction or fixing basis (once per session). The more liquid securities are quoted on a
continuous basis. The electronic trading system automatically downloads to a market information
system. This means that data providers can receive real-time market data (time, price, number of shares
traded, etc), just as it appears on the dealers' screens.


  

 
   
' 
 


 
The sudden supply of vast amounts of mobile capital in the early 1990s created an environment
conducive for the emergence of stock markets in Africa. Nevertheless, up until now, portfolio inflows to
Africa have been disappointing. One possible reason for this unfavourable scenario is that the
acquisition of shares by foreigners is limited on some African stock markets (see Table 3). The
prohibitive institutional barriers, trading costs, and factors such as foreign exchange risk, political risk
and informational and institutional barriers, act as disincentives to foreign portfolio investments. Some
African stock markets still operate in regulatory environments with restrictive capital flow controls on
the remittance of capital, capital gains, dividends, interest payments, returns and other earnings
(Mlambo and riekpe, 2001).

@
E 1: Age and size of African Stock Market

In Malawi, for example, the Reserve rank of Malawi (RrM) manages the exchange control. Foreign
investment capital, whether in the form of equity or loans, needs to be registered with the RrM. Foreign
loans and equity investments, the remittance of dividends and capital, among other transfers, require
permission from the RrM. In the case of Mozambique, remittance of funds overseas is restricted.
Foreign investors can remit loan repayments, dividends and capital if permission has been obtained for
amounts above US$5000. In Zimbabwe, dividend remittances in respect of projects approved by the
Zimbabwe Investment Centre are allowed at 100 percent of after tax profits. Capital is blocked and may
be remitted through 20-year 4 percent government bonds, denominated in Zimbabwean dollars. Capital
is paid in 10 equal annual instalments at the end of years 11 to 20.
In some countries such as rotswana, Mauritius, Zambia and Uganda, there are no foreign exchange
controls. Profits, dividends and capital can be freely repatriated. In Ghana, the financial regime is
relatively flexible and allows the free transfer of foreign currency in and out of Ghana. A foreign investor
may, subject to approval, operate a foreign currency account with banks in Ghana. In Kenya, the Foreign
Investment Protection Act guarantees that foreign investors can convert and repatriate capital freely.
The Exchange Control Act was repealed in 1995, removing the last of the restrictions on profit
remittances and borrowing. Namibia, as part of the Common Monetary Area (CMA) with South Africa,
Swaziland and Lesotho, has unrestricted capital flows for non-residents. Capital, profits and dividends
can be repatriated. Exchange control limitations do apply to resident capital flows. South Africa has
adopted the approach of gradually abolishing exchange controls. Restrictions on nonresident capital
flows were fully liberalised with the abolition of the financial Rand in 1995. Restrictions on residents are
gradually being relaxed. In Swaziland, there are no foreign exchange restrictions between CMA
members. Nevertheless, exchange controls between CMA members and the rest of the world may not
be less strict than those of South Africa.

@
E 2: Trading Arrangements on African Stock markets, 2002

¢r "6: Trading costs and foreign investment restrictions
In Tanzania, foreign exchange controls were removed through the Foreign Exchange Act of 1992. Capital
transfers are nevertheless still subject to approval by the rank of Tanzania. Profits and dividends can be
fully repatriated. In Nigeria, foreign investors are guaranteed unconditional transfer of their capital and
profits. Importation or exportation of foreign exchange above US$5 000 is declared. A domiciliary
account can be opened in foreign currency at banks and cash withdrawals from such accounts are
permissible. For purposes of exchange control and monitoring the flow of foreign currencies, authorised
dealers are required to inform the central bank whenever transfers larger than US$10 000 are made into
a domiciliary account.
 



Some of the African stock markets were established on the back of poor regulatory and legislative
frameworks. This, among other things, explains why some of these markets lack the capacity to deal
with capital market dynamics. Legislations to prevent insider trading are either inadequate or non-
existent, and where they exist, enforcement is often poor. The inadequacy of insider trading laws on
African stock markets has enhanced the perception that these markets are not efficient. Insider trading
has been one of the problems historically faced by the JSE. South Africa is one of the countries in Africa
with insider trading laws. Nevertheless, no prosecution for insider trading has taken place in South
Africa due to the inadequacy of the legislation and the existence of lax and unenforceable laws.
The successful integration of African markets into the world financial system requires regulatory
frameworks that conform to international standards. An appropriate legal and regulatory framework,
sufficiently monitored, is a necessity to protect investors and the integrity of the markets. It also helps
to instil confidence, a sense of fairness and financial discipline in the market. In most countries the
regulator is a government agency, the central bank, finance ministry or an independent commission (see
Table 3). In some countries, the capital market is accorded regulatory powers to become a self-
regulatory body, or the power to regulate is a shared responsibility between two or more agencies.



 

 
African stock markets are also known to be illiquid and characterised by thin trading (Mlambo and
riekpe, 2005), in comparison to stock markets in other regions. According to Kenny and Moss (1998), 8
of the world͛s 12 most illiquid stock exchanges in 1995 were in Africa. Expected annual volatility is also,
on average, high on the African markets. In Erb, Harvey and Viskanta. (1996), volatility was an average
35,6 percent on African markets compared to 21,4 percent for the Morgan Stanley Capital International
(MSCI) developed equity markets, measured using the countries͛ risk ratings. Kenny and Moss (1998)
suggested that this extreme volatility is a result of the small size nature, lack of liquidity and, often,
unstable political and economic environments. The higher expected volatilities on the African stock
markets, implying higher risk, nevertheless, also imply higher expected returns as compensation for the
risk. Erb, et al. (1996) found the average expected return for Africa to be quite high at 18.4 percent. The
ability of African markets to attract investors, despite the high risks, rests upon the relatively higher
returns these markets potentially give on investments.
African stock markets lack integration with world equity markets and also with each other. Erb, et al.
(1996) found the average correlation of African stock markets with world equity markets to be a low
0.05 percent. The segmentation of African markets implies that investors demand compensation in the
form of higher expected returns for their risk exposure. Nevertheless, the lack of integration of African
stock markets with global equity markets make them potentially good portfolio diversifiers. African
markets, except the JSE, were not affected by the Asian crisis due to the lack of interdependence with
other global emerging markets (Collins and riekpe, 2001).
 

 


 
A stock market is perceived by African governments to be an indication of integration into the global
economy. It is considered to be a sign of international legitimacy and a measure of a country͛s
modernisation and commitment to private sector-led development (Moss, 2004). Therefore, the
emergence of stock markets on the African continent seems more like an explicit response by African
governments to globalisation and a desire to be included. In Africa, a stock market is regarded as a
symbol of national prestige and progress, similar to a national airline, or a mark of sovereignty, similar to
flags or national anthems (Turner, 1999). According to Moss (2004), both the national airline and the
stock exchange serve very significant symbolic and practical purposes, yet they come at a cost that may
not rationally justify their existence.
The symbolic significance of a stock market to African governments has contributed to the lack of
progress in integrating regional stock exchanges. The critical prohibiting factor is location. The African
Stock Exchange Association (ASEA) has a long-term plan to consolidate the various national stock
exchanges into regional hubs based in Johannesburg, Nairobi, Abidjan, Lagos and Cairo. According to
Mlambo and riekpe (2001), an integrated real time network for SADC stock exchanges was expected to
be up and running by the year 2006 but it has not yet materialised. The only regional stock exchange in
Africa, the rourse Régionale des Valeurs Mobilières (rRVM) was made possible by the fact that Cote
d͛Ivoire had been the only West African franc zone member country with a Stock Exchange and Abidjan
was by far the main commercial centre in the zone.
Even though Gabon was pushing to have the exchange located in its capital Libreville, the other
members resisted, with each of them wanting to play host (Moss, 2004). The rRVM serves the 8 French
speaking member countries of the West African Economic and Monetary Union (UMOEA), namely
renin, rurkina Faso, Cote d͛Ivoire, Guinea rissau, Mali, Niger, Senegal and Togo.
The problem of location is not only with regional stock exchanges but national stock exchanges as well.
The Nigerian Stock Exchange (NSE) was established as the Lagos Stock Exchange in 1960. When the
government moved offices to Abuja in 1991, there were fears that the newly privatised enterprises
might still use Lagos as their headquarters instead of moving to the new capital, Abuja. Therefore,
propositions were made to open another stock exchange in Abuja and a branch of the NSE was recently
opened there. If Africa could embrace Information Technology, a physically existing brick-and-mortar
exchange trading floor would become less significant as the trend is moving towards electronic trading.
Therefore, the issue of location will inevitably be resolved. Electronic trading will also encourage
liquidity and efficiency, two characteristics that have been lacking on the African stock markets.
¢¢¢ "# .;
The markets studied in this paper are Egypt, Kenya, Zimbabwe, Morocco, Mauritius, Tunisia, Ghana,
Namibia, rotswana and the West African Regional Stock Exchange (rourse Regionale des Valeurs
Mobilieres - rRVM) in Cote d͛Ivoire. The data used in this study are daily closing stock prices and volume
traded for individual stocks. The data for Egypt, Kenya, Zimbabwe, Morocco and Mauritius were
obtained from DataStream and comparisons were made with samples from the respective stock
exchanges and/or stockbrokers (e.g. the Nairobi Stock Exchange for Kenya, Casablanca Stock Exchange
for Morocco, rARDNET and Kingdom Stockbrokers for Zimbabwe) to determine reliability and accuracy.
For rotswana, Namibia and the rRVM, the data were obtained from the respective stock exchanges
while for Ghana and Tunisia at least two sources were consulted. These are Tunisie Valeurs, Tustex and
Financiere de Placement et de Gestion (FPG) for Tunisia; Databank and SDC rrokerages for Ghana.
For all the markets in the study, volume traded data were obtained and used to determine the trading
frequencies and durations of non-trading of the different stocks. A stock is included in the sample as
long as it has been listed for the entire period under consideration; it has not been part of an acquisition
or merger during the period under review; it has not been suspended from trade for a period longer
than a week; and it has enough data points to make a meaningful analysis. The period examined for
each market is shown in Table 4, which also shows the thin-trading frequencies for each market.
As can be seen from Table 4, the markets in this study exhibit serious thin-trading for the periods under
investigation. For Namibia, the lowest thin-trading frequency is 62 percent. If such a thin-trading
frequency is considered serious, then all the stocks in the Namibian sample can be said to have serious
thin-trading. Other relatively thin-traded markets are rotswana with the lowest thin-trading frequency
of 34 percent and Mauritius with 14 percent. Interestingly, most of the stocks on the Namibian and
rotswana stock exchanges have dual listings on the JSE. Probably, trading in these stocks takes place
more on the JSE than on these other markets. recause the majority of stocks on the Namibian Stock
Exchange (NSX) are dual-listings on the JSE (68 percent of stocks in our sample), the NSX is usually not
open for trade whenever there is a holiday in South Africa.
This paper uses continuously compounded returns calculated on a trade-to-trade basis and adjusted for
interval variability, following Mlambo et al. (2003)7. According to Mlambo and riekpe (2005), the
conclusion on whether a market is efficient or not is subject to the methodology used, especially in
adjusting for the thin-trading effect. rowie (1994) argued in favour of the trade-to-trade approach in
measuring stock returns on a thinly traded market.
 @
E 4: Data and thin-trading properties

`
: *The variability in the sampling periods is due, among other reasons, to the availability of the data. The rRVM, for
example, was established towards the end of 1998 and thus the data series could only start after 1998. Mauritius, though
established in 1989, changed to daily trading in 1998 and therefore this period was chosen so as not to distort the data series.
The rotswana Stock Exchange only started recording transactions data on a daily basis in March 1998 when it introduced the
computerised trading system. A large number of stocks were listed on the Tunisian Stock Exchange after the introduction of
electronic trading in 1997 and thus the choice of this starting date. For Ghana it was difficult to access data prior to 1998. Thin-
trading frequency is measured as the number of days a stock does not trade out of the total number of days the stock exchange
was open for trade for the period studied. A thin trading frequency of 62 percent would imply a stock not trading in 62 out of
every 100 trading days.

The adjusted trade-to-trade returns are calculated as follows:

|
Ë    & &   (1)

where:
Ë is the trade-to-trade return adjusted for the interval effect
 is the stock¶s traded price in period Ê
&  the price of a stock Kt periods in the past
Kt is the length of time (in days) between the trade in period Ê and the previous successive trade

Nevertheless, even when returns are calculated on a trade-to- trade basis, there is still a high prevalence
of zero returns (see Table 5). This implies that in most cases stocks changed hands without having an
impact on the stock prices. For Ghana, between 57 percent and 82 percent of the trade-to-trade returns
are zero returns, while for the rRVM the trade-to-trade zero returns range from 43 percent to 85
percent of the total returns calculated. Only Egypt has relatively low percentages of trade-to-trade zero
returns ranging from 2 percent to 23 percent of the trade-to-trade returns calculated. These zero
returns are likely to lead to positive serial correlation in the return series. Therefore, the trade-to-trade
approach will only reduce, but not eliminate, the bias on our findings towards the rejection of serial
independence.
" *¢ "ãc ã
The returns were tested for normality and all the stocks rejected the normality assumption using the
Kolmogorov-Smirnov test at the 1 percent level of significance. Due to the non-normality of the returns
series, a nonparametric measure for independence, that is, the runs test, is used. This test is not
affected by any extreme values in the return series (Dickinson and Muragu, 1994) and thus does not
require constant variance of the data (rarnes, 1986). The hypothesis of independence is tested using the
significance of the standardised Z-values at the 5 percent level of significance. This statistic compares
the observed and expected number of runs. The observed number of runs is the sequences of price
changes of the same sign. The total expected number of runs (m) is computed as follows, (see Fama,
1965):

 |&Þ




&|
  (2)
where ‘ is the total number of price changes and i n (
=1,2,3) are the numbers of price changes of each
sign - positive, negative and zero.

@
E 5: nalysis of zero returns

Country/Stock Stock Days Zero returns ( ¶@rue¶ zero
Exchange market actually percent) returns (
trading traded percent)
days
rotswana 1035 65 to 677 81 to 85 9 to 71
r
M 687 34 to 664 55 to 98 43 to 85
Egypt 1342 345 to 1277 6 to 78 2 to 23
Ghana 753 143 to 684 65 to 94 57 to 82
Kenya 1366 38 to 1338 31 to 98 21 to 45
Mauritius 1197 575 to 1033 56 to 76 46 to 56
Morocco 1349 33 to 1336 22 to 98 18 to 39
Namibia 1341 31 to 503 55 to 97 9 to 61
Tunisia 1250 107 to 1293 18 to 94 15 to 72
Zimbabwe 1353 81 to 1293 40 to 86 31 to 49
Stock market trading days: These are made up of the number of days a stock exchange was open for trade for the period under
investigation
Days actually traded: These are the number of days when trade took place for each stock
Zero returns: These are the number of days recording a zero return for each stock as a proportion of the number of days the
respective stock exchange was open for trade, and are thus recorded as percentages.
µTrue¶ zero returns: These are the number of days recording a zero return for each stock when the stock actually traded or changed
hands as a proportion of the number of days trade actually took place for the stock, Also given in percentages.
As per Fama (1965), for large n, the distribution of  is approximately normal and the Z-value is
calculated as follows:
|
 &
+
(3)


where r is the observed number of runs, the ͞½͟ is the discontinuity adjustment factor and m ʍ is the
standard error of m and is given by:
|
 
 
 


 Þ | Þ
È  È |


Þ 
 
Ä  |  |  |  e/
 
|



 

where all the variables are as defined before A negative Z-value implies that the observed number of
runs is less than the expected number of runs and thus positively correlated. The opposite is true for a
positive Z-value.
The majority of stocks for Ghana and Mauritius rejected the random walk hypothesis using the runs test.
Whereas 80 percent of stocks rejected the random walk hypothesis for Ghana, on the Stock Exchange of
Mauritius, all the stocks in the sample rejected the random walk hypothesis at the 1 percent level of
significance. For the other markets, more than half of the stocks for the rRVM (54 percent) and Egypt
(54 percent) and exactly half the stocks for rotswana also rejected the random walk hypothesis using
the runs test, whilst for Kenya, Zimbabwe, Tunisia and Morocco, less than half of the stocks in the
respective samples rejected the hypothesis. For all the markets, except Kenya, the runs test indicates
positive correlation tendencies for most stocks, when disregarding significance (see Table 6). The
deviations from the random walk by the stocks on these markets suggest that the possibility of detecting
patterns, which can be profitably traded upon, cannot be entirely dismissed. One clear exception is
Namibia, where all the stocks in the sample, except one, exhibited random walk behaviour at the 5
percent level of significance. Kenya and Zimbabwe are also considered to be weak-form efficient since
the majority of stocks conformed to the random walk hypothesis.
#
 


 




 
rekaert and Harvey (2002) indicated that emerging market stock returns exhibit higher order serial
correlation. To investigate this assertion in the current research, a hypothesis that the correlation
coefficients of trade-to-trade returns at all lags are zero is tested against the alternative that not all
correlation coefficients are zero. This hypothesis is tested using the rox-Ljung Q-statistic, which is chi-
2
square distributed with › degrees of freedom (K ). The null hypothesis that all the ten correlation
coefficients are zero is rejected if the Q-statistic for the 10 lags is significant at the 5 percent level of
significance. The results, as summarised in Table 7, show that more than half of the stocks for each
market, except Namibia and Zimbabwe, exhibit significant higher order serial correlation at the 5 percent
level of significance.

TArLE 6: Number and proportion of stocks with significant Z-values for the uns test

@
E 7: Number of significant higher order serial correlation coefficients and the proportions of
significant rox-Ljung Q-statistics
Table 7 also shows that the numbers of significant coefficients decrease with increasing lags for both the
autocorrelation function (ACF) and the partial autocorrelation function (PACF), but only gradually.
Hence, while stock returns in the immediate past provide information that play a significant role in
determining future returns, the information becomes less and less useful the further away in the past
one looks. Nevertheless, for the African stock markets in this study, the importance of historical price
information only dissipates gradually and is hence not totally irrelevant in forecasting future returns.
Discussion of results
The positive serial correlation observed on most of the markets is not surprising considering that daily
data was used for an average period of 5 years. Positive serial correlation is usually considered to be a
predictability phenomenon of the short-run, while negative serial correlation is mostly a long run
predictability phenomenon. The positive serial correlation on African stock markets might also be a
result of institutions imitating spreading their trades over several days to lessen the impact of trades in
large volumes on the market (Asal, 2000). Most significantly, the prevalence of zero returns on these
African stock markets as discussed in section 3 could have contributed to the nature of the results. The
weak-form efficiency of the NSX can probably be explained by the market͛s positive correlation with the
JSE due to the significant number of stocks that are dual-listed on both markets. Tyandela and riekpe
(2001) found the correlation of the two markets to be 90 percent and the highest for all the market
correlations that they studied. Considering some of the recent studies, the JSE was found to be efficient
in Magnusson and Wydick (2002), Smith, Jefferis and Ryoo (2002) and Smith and Jefferis (2002). If the
JSE is weak-form efficient, then one can argue that this efficiency filters through to the NSX since almost
the same stocks are traded on both markets. About two-thirds of the stocks, which make up the sample
for Namibia, are dual-listed on the JSE. The efficiency of the NSX can thus be said to be a spill-over from,
or a reflection of, the weak-form efficiency of the JSE.
The efficiency of Kenya and Zimbabwe is also not surprising since the two markets are among the oldest
in Africa. The two markets, probably, gained some sophistication over the years, enabling them to
interpret and incorporate information into prices speedily. Fama (1965, p38) highlighted the importance
of many sophisticated traders in a market, who can recognise situations where the price of a stock runs
well above or below its intrinsic value, and who through their actions would cause such price bubbles to
burst before they get underway.
The deviation from the random walk portrayed by the sampled stocks listed on the stock exchange of
Mauritius cannot be readily explained. The rejection of the random walk hypothesis on this market
might indicate the availability of exploitable profit opportunities, which may be due to investors not
reacting quickly to new information and thus a slow adjustment of prices. Investors also, probably,
adopt a passive investment strategy thereby failing to identify situations when prices deviate from their
intrinsic values. The rejection of the random walk by some Ghanaian stocks could be due to limited
trading time on this market. The Ghana Stock Exchange was trading only three times a week, on
Mondays, Wednesdays and Fridays for the period under study. This could have resulted in price
adjustment delays and thus partly explain why stock prices on this market deviate from the random
walk. If new information arrived on a Tuesday, which was a nontrading day on the Ghana Stock
Exchange, investors would be in a position to reasonably predict the price movements for Wednesday
when the stock market opens for trade.
The Z-values of the runs test are, nevertheless, small in magnitude for some stocks, but relatively large
for others in comparison to those obtained in, for example, Fama (1965) and Dickinson and Muragu
(1994). The largest Z-values, which are significant at the 1 percent level, exceed 5.0 for a number of
stocks across markets, reaching to as high as 9,546 for Ghana. In Fama (1965), the largest standardised
value for the runs test, also in absolute terms, was 4.23. Dickinson and Muragu (1994) also found very
small values in their study of the Nairobi Stock Exchange, with the largest Z-values in absolute terms of
2,987. While Fama (1965) and Dickinson and Muragu (1994) hinted that the serial correlation they found
may not be attractive to investors, the same cannot be readily said for the African stock markets
studied. One major concern would be the illiquidity of these markets.
CONCSION
The paper investigated the weak-form efficiency of ten African stock markets using the runs test
methodology for serial dependency. Returns were calculated on a trade-to-trade basis and weighted by
the number of days between trades. Serious thin-trading was observed on all markets, and more so for
Namibia and rotswana, the two markets with significant dual-listed stocks on the JSE. In all the markets
studied (except Namibia), a significant number of stocks rejected the random walk. The weak-form
efficiency of the NSX was attributed to its correlation with the JSE. Kenya and Zimbabwe were also
concluded as generally weak form efficient, since a significant number of stocks conformed to the
random walk. All the stocks in the Mauritius sample rejected the random walk at the 1 percent level of
significance using the runs test. This led to the conclusion that stock prices on the Mauritius market tend
to deviate from the random walk hypothesis. The same conclusion was made for Ghana. On the rRVM,
Egypt and rotswana stock exchanges, chances that one can detect patterns in the stock prices that can
used to predict the next price also could not be ruled out. Since rejection of the random walk does not
necessary imply weak-form inefficiency, but the presence of serial correlation in stock returns, it is vital
to investigate if such serial correlation can be exploited for abnormal returns, net of transaction costs.
Hence, there is need for further tests using technical trading methods that try to profitably exploit the
serial correlation observed in this study, in order to reach definite conclusions on the efficiency or
inefficiency of the African stock markets in this study.
The runs test used here only tests for the existence of a linear relationship, which makes it inadequate
as a testing method on African stock markets where the return-generating processes are assumed to be
nonlinear. This is for the reason that the assumptions on which the EMH is based are believed to be
violated due to the heterogeneity of investors and the weak microstructures of the markets. The use of
linear models would thus lead to wrong inferences being drawn. Hence, further research is required to
test the random walk hypothesis using nonlinear models and to investigate if the observed patterns can
be profitably exploited.
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< 
 

1. Which factors according to you violated the efficient market hypothesis in the above case study
according to you?
2. Do you think that technical trading method will solve the problem which the African stock
markets faced earlier?
 c
3


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There always is a cost of initiating a business that ought to serve as your benchmark for how you devote
in long-term assets. This cost is known as Cost of Capital. Cost of Capital is the price you pay to those
who lend or spend money into your business. You can think of Cost of Capital as the rate of return
investors need for incurring risk every time they give you money. Cost of Capital applies to long-term
funding of assets as contrasting to short-term funding of working capital.
Why is Cost of Capital so important? Well, you have to earn by and large rate of return on your assets
that is higher than your cost of capital. If not, you end-up destructing value. So how do you calculate
Cost of Capital? The popular approach is known as the Capital Asset Pricing Model or CAPM. CAPM
estimates your cost of equity by taking a risk free rate and adjusting it by risks that are unique to your
company or industry. Long-term government bonds are often used to calculate approximately risk free
rates while overall market premiums run around 6 percent.
CAPM is not ideal since it has numerous impractical assumptions and variations in estimates. For
instance, sources (rloomberg, S & P, etc.) for reporting market risks of specific companies offer very
dissimilar estimates. In addition you might find straightforward estimates are just as accurate as CAPM.
For instance, simply adding 3 percent to your cost of debt may provide a reasonably accurate estimate
of your cost of capital. You can also see at companies that are very alike to your company. In any event,
you necessitate calculating your cost of capital since it is an tremendously significant constituent in
financial management decision making.
Capital for investment is provided to the firm by investors who hold various types of claims on the firm͛s
cash flows. Debt holders have bonds that promise to pay them fixed amount of interest and principal in
the future in exchange for their cash now. Equity holders provide retained earnings or buy rights
offerings (internal equity provided by existing shareholders) or purchase new shares (external equity
provided by new shareholders). They do so in return for claims on the residual earnings of the firm in
the future. Also, shareholders retain control of the investment decision, whereas bondholders have no
direct control except for various types of indenture provisions in the bond that may constrain the
decision making of shareholders. In addition to these two basic categories of claimants, there are others
such as holders of convertible debentures, leases, preferred stock, nonvoting stock, and warrants.
Each investor category is confronted with a different type of risk, and therefore each requires a different
expected rate of return in order to provide funds to the firm. The required rate of return is the
opportunity cost to the investor of investing scarce resources elsewhere in opportunities with
equivalent risk.
Whether or not an optimal capital structure exists is one of the most important issues in corporate
financeʹand one of the most complex. This unit covers the effect of tax-deductible debt on the value of
the firm, first in a world with only corporate taxes, then by adding personal taxes as well. Next the effect
of business disruption and bankruptcy costs is introduced, and we extend the basic Modigliani-Miller
model using the work of Leland. The result is an equilibrium theory of capital structure. The unit also
covers nonequilibrium theories that include the pecking order theory, signaling, and the effect of
forgoing profitable investments. There is also a discussion of the effect of risky debt, warrants,
convertible bonds, and callable bonds.
#"9¢ c"h#"h .9"*¢"¢?"ã ;
At the same time as tax consequences are a motivating factor in numerous corporate decisions,
managerial actions designed exclusively to reduce corporate tax obligations are thought to be an ever
more significant feature of U.S. corporate activity. Do such activities advance shareholder interests? If
prevention activities are costless to investors, the question is trivial as prevention activity outcome in a
transfer of value from the state to shareholders. Undeniably, this has been the presumption in the large
literature on the effects of taxes on financial decision-making. Corporate tax avoidance activity,
nonetheless, may be costly on numerous margins. Aside from the direct costs of engaging in such
activities, managers characteristically have to make sure that these actions are obscured from tax
authorities. In the process, such machinations may afford managers enlarged latitude to pursue self-
serving objectives. Can the latter result be noteworthy enough to change the simple answer that
investors fully incarcerate the value of corporate tax avoidance activity?
Two little sample studies show that the estimation of tax avoidance activities may not be conventional
to the simple story of tax avoidance as a transfer of value to shareholders. First, corporate deportations
- transactions where U.S. firms turn upside down their corporate structure so that a supplementary in a
tax haven becomes the parent entity - provide important corporate tax savings with limited, if any,
operational changes. Nevertheless, markets do not react in a strongly positive fashion ʹ and often react
negatively ʹ to U.S. firms announcing such moves (e.g. Desai and Hines, 2002). Second, an event study of
an episode of augmented tax enforcement in Russia shows that these enforcement actions are related
with positive market reactions (Desai, Dyck and Zingales, 2007). These small sample studies are
challenging but leave open questions about the nature of corporate tax avoidance activity in general and
in bigger samples.
Here we will examine the degree to which corporate tax avoidance activity is valued by investors in a
large sample of US firms. While the conventional analysis of corporate tax avoidance suggests that
shareholder value should augment with tax avoidance activity, an agency perspective on corporate tax
avoidance gives a more nuanced prediction. Exclusively, firm governance should be a significant
determinant of the valuation of purported corporate tax savings. While tax avoidance per se should
augment the after-tax value of the firm, this consequence is potentially offset, predominantly in poorly-
governed firms, by the enlarged opportunities for rent diversion provided by tax shelters. Hence, the net
effect on firm value should be greater for firms with stronger governance institutions.
The associated advantages of these two views of tax avoidance are evaluated using a dataset with 4,492
observations on 862 firms over the period 1993-2001. This panel is drawn from the Compustat and
Execucomp databases, combined with data on institutional possession of firms from the CDA/Spectrum
database. Firm value is measured using Tobin͛s q, and governance quality is proxied for by the level of
institutional possession, reflecting the ability of institutional owners to keep an eye on managerial
performance more forcefully. Tax avoidance is considered by inferring the differentiation between
income reported to capital markets and tax authorities ʹ the book-tax gap ʹ and controlling for accruals
and other measures of earnings management. The analysis shows that, for a given firm, this measure
takes on higher values in years when the firm is implicated in litigation relating to aggressive tax
sheltering activity than in other years. OLS results show that, controlling for a range of other relevant
factors together with firm and year fixed effects, the effect of the tax avoidance measure on q is
positive, but not appreciably distinct from zero. As anticipated predicted by the agency perspective on
corporate tax prevention, the effect is positive for those firm-years with high levels of institutional
ownership. The explanation of these results, nevertheless, is convoluted by the possibility of
measurement error in the proxy for tax avoidance and by the potential endogeneity of tax avoidance
commotion.
In particular, it is probable that firms that are performing worse for exogenous reasons may be more
likely to engage in tax avoidance. Luckily, a 1997 regulatory change inadvertently and considerably
changed the costs of tax sheltering differentially across firms. This source of exogenous variation
permits the execution of an instrumental variables strategy that can be used to address these concerns
and to investigate the causal effect of tax avoidance on firm value.
The ͞check-the-box͟ set of laws were planned to allow small firms to choose their executive form for tax
purposes. Altshuler and Grubert (2005) and different practitioners have observed that these regulations
also had the inadvertent outcome of lowering the costs of tax avoidance for firms. Particularly, ͞hybrid
entities͟ became more and more common. These entities are classified as independently incorporated
subsidiaries under the tax rules of one country while at the same time being treated as unincorporated
branches under the tax rules of a new country. This flexibility in entity classification creates a sizable tax
avoidance opportunity for firms with incentives to capitalize on these regulatory changes. The middle
idea underlying the identification strategy is that, for a given enticement to fit into place in tax evasion,
a firm will engage in more actual tax evasion after the ͞check-the-box͟ regulations were adopted. A
crucial determinant of the incentives to engage in tax avoidance is the availability of ͞tax shields.͟ Thus,
instruments for tax avoidance are constructed by interacting a dummy variable for the period after the
͞check-the-box͟ regulations with variables (at the firm-year-level) that proxy for the availability of tax
shields, namely NOL carryforwards and two different measures of debt.
The estimates using the instruments described beyond lead to results that are in the same direction as
the OLS results, but are significantly stronger. The communication between institutional ownership and
tax evasion is positive and important, as anticipated by the agency perspective on tax avoidance. This
outcome is vigorous to the inclusion of different additional control variables, and to a mixture of
extensions to the model. The exclusion restriction underlying the results may be unacceptable if the
effect on firm value of the tax shield variables changed over time for reasons not related to the ͞check-
the-box͟ regulations. Reassuringly, the basic result is robust to together with interactions between
these variables and time trends in the model. ry and large, the considerably better effects found using
the above approach suggests that the OLS results are considerably exaggerated by attenuation bias due
to measurement error in the tax avoidance proxy or by the endogeneity of tax avoidance.
 

 

¢
 
The ostensible growth in corporate tax avoidance activity has given rise to two substitute perspectives
on the motivations and possessions of this activity. Numerous studies investigate corporate tax
avoidance as an addition of other tax-favored activity, such as the use of debt. In general, Graham and
Tucker (2006) build a sample of firms involved in 44 corporate tax shelter cases over the period 1975-
2000. ry comparing these firms with a harmonized sample of firms not involved in such litigation, they
recognize characteristics (such as size and profitability) that are absolutely related with the use of tax
shelters, and argue that tax shelters serve as a replacement for interest deductions in determining
capital structure.
A substitute notional approach put stress on the interaction of these tax avoidance activities and the
agency problems that are intrinsic in publicly held firms. As per this view, obfuscatory tax avoidance
activities can create a shield for managerial opportunism and the diversion of rents. This perspective
underlies numerous recent studies, together with Desai and Dharmapala (2006a) and Desai, Dyck and
Zingales (2007), and forms part of an emerging paradigm that emphasizes the links between firms͛
governance arrangements and their responses to taxes. In this view, corporate tax avoidance not only
means different costs, but these costs may in fact outweigh the reimbursement to shareholders, given
the opportunities for diversion that these vehicles offer. Desai and Dharmapala (2006b) discuss
examples of the interaction between tax shelters and various forms of managerial opportunism,
exemplifying that straightforward diversion and subtle forms of earnings treatment can be facilitated
when managers assume tax avoidance activity.
While the conventional view of corporate tax avoidance suggests that shareholder value should
augment with tax avoidance activity, the alternative view gives a more nuanced prediction. Particularly,
firm governance should be a significant determinant of the valuation of alleged corporate tax savings.
While the direct effect of tax avoidance is to augment the after tax value of the firm, these effects are
substantially offset, chiefly in poorly-governed firms, by the increased opportunities for managerial rent
diversion. Consequently, the net effect on firm value should be better for firms with stronger
governance institutions.
 

h

9.
  

¢
 
The data used to test the proposition described above is drawn from three sources. Financial accounting
data is drawn from Standard and Poor͛s Compustat database, executive compensation data (and certain
other control variables) from Standard and Poor͛s Execucomp database, and data on institutional
ownership of firms from the CDA/Spectrum database. Integrating these variables leads to a dataset with
4,492 explanation at the firm-year level, on 862 firms over the period 1993-2001. The variables are
described in detail below; summary statistics are reported in Table 4.1.
$30ã
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Mean Standard Number of
Deviation Observations
Tobin͛s q (excluding deferred tax expenses) 2.3537 2.2885 4,492
Tobin͛s q (including deferred tax expense) 2.3123 2.0011 4,062
Market Value (scaled) 1.7825 2.2881 4,470
rook-tax Gap (scaled) ʹ0.0074 0.1077 4,492
Total Accruals (scaled) ʹ0.0432 0.0787 4,492
Ratio of Value of Stock Option Grants to Total Compensation 0.4066 0.2542 4,492
for Top 5 Executives
Value of Stock Option Exercises by Top 5 Executives (scaled) 0.0061 0.0257 4,492
Sales (millions TZSs) 3.5831 8.3074 4,492
Volatility (rlack-Scholes measure) 0.4021 0.1864 4,492
Net Operating Loss (NOL) Carryforwards (scaled) 0.0351 0.2074 4,492
Foreign Income of Loss (absolute value; scaled) 0.0327 0.0401 4,492
R&D Expenditures (scaled) 0.0475 0.0666 4,492
Long-term Debt (scaled) 0.1748 0.1537 4,492
Debt in Current Liabilities (scaled) 0.0387 0.0608 4,492
Deferred Tax Expense (scaled) 0.0256 0.0345 4,062
Future Sales Growth (fraction) 0.1077 0.2984 4,328
Capital Expenditures (scaled) 0.0674 0.0505 4,433
Pretax Income (scaled) 0.0544 0.1363 4,492
Governance Index, 1998 9.2650 2.8387 3,906
Institutional Ownership (fraction) 0.5853 0.1768 4,492
: These variables are defined as in the text. ͞Scaled͟ variables are deflated by the contemporaneous book value of assets.
In stressing the value entailments of corporate tax avoidance, this discussion builds on the extensive
literature in corporate finance on the epitopes of firm value. Inside this literature, it has become
standard since Demsetz and Lehn (1985) to use Tobin͛s q to measure firm value. The definition of q used
in Kaplan and Zingales (1997) and Gompers, Ishii and Metrick (2003) is employed in the analysis below,
with one modification: deferred tax expense is not incorporated in the definition of q used in the basic
results below, as current tax avoidance activity may result in changes to future tax liabilities and thus
create a mechanical correlation between the dependent variable and the measure of tax avoidance.
While q is the primary dependent variable used in the analysis, alternative measures of firm value lead
to consistent results.
In summation to drawing on financial statement data, the analysis below necessitates a measure of firm
governance. The basic measure of governance used in testing the paper͛s chief hypothesis is the fraction
of the firm͛s shares owned by institutional investors. This fraction (which is reported quarterly) is
averaged over each firm-year, and is denoted by Oit ̿ [0, 1] for firm  in year . The basic motivation
underlying this proxy is that institutional investors have greater incentives and capacity to monitor
managerial performance. Thus, the higher is Oit, the greater the degree of examination to which
administrative actions are subjected, and the less significant are agency problems between managers
and shareholders. In addition, a different measure ʹ the index of antitakeover provisions constructed by
Gompers, Ishii and Metrick (2003) ʹ is used in sturdiness checks. While this captures a quite diverse
aspect of governance than does Oit (namely, managerial entrenchment rather than the quality of
monitoring), its use leads to highly reliable results.
Given the efforts undertaken to unclear such activities, tax avoidance is complicated to measure. The
analysis adopts an roundabout approach, constructing a measure of corporate tax avoidance that takes
as its starting point the gap between financial and taxable income. The difference between income
reported to capital markets and to the tax authorities ʹ the so-called book-tax gap ʹ has attracted
significant interest in recent years, and has been related to measures of corporate tax avoidance. Given
that tax returns are confidential, income reported to tax authorities cannot be observed directly and
must be inferred using financial accounting data, as described in Manzon and Plesko (2002) and
implemented in Desai and Dharmapala (2006a). This approach uses firms͛ reported current Federal tax
expense and ͞grosses up͟ this tax liability by the US Federal corporate tax rate. For firms with positive
current Federal tax expense, the graduated structure of corporate tax rates is used in this calculation.
For firms with negative current Federal tax expense, the top statutory rate of 35 percent is used.
Given this indirect value of the firm͛s taxable income, the book-tax gap can be anticipated by simply
subtracting inferred taxable income from the firm͛s reported pretax (domestic US) financial income.6 To
control for differences in firm scale, and for the reason that the dependent variable is deflated by the
book value of assets, the inferred book-tax gap is also scaled by the book value of assets. This yields the
measure of the book-tax gap used in the analysis below (denoted rit for firm  in year ).
The book-tax gap does not essentially reflect corporate tax avoidance activity, so any measure of tax
avoidance must control for other factors. Specifically, the overreporting of financial income (known in
the accounting literature as ͞earnings management͟) may contribute to the measured book-tax gap.
Studies of earnings management (e.g. Healy, 1985) have argued that such exploitation is most likely to
take place through the exercise of managerial discretion in determining accounting accruals (i.e.
adjustments to realized cash flows that are used in calculating the firm͛s net income). The basic intuition
underlying the measure of tax avoidance used here is that book-tax gaps are attributable either to
earnings management or to tax avoidance activity. Accordingly, adjusting for earnings management with
an accruals proxy isolates the component of the gap that is due to tax avoidance. In the regressions
reported below, rit is used as a proxy for tax avoidance activity, while earnings management is
controlled for by including a measure of total accruals (denoted it for firm  in year ) as a control
variable.
Given the privacy of tax returns, the procedure outlined above yields the best measure of corporate tax
prevention that can be obtained using publicly-accessible data. Nevertheless, in view of the limitations
associated with inferring taxable income, and as there are alternative explanations for book-tax gaps, it
is important to put into practice a validation check of the book-tax gap as a measure of corporate tax
sheltering activity before proceeding to determine its valuation effects.
Graham and Tucker (2006) build a sample of firms involved in 44 cases of tax shelter litigation over the
period 1975-2000, using publicly-available court records and press articles. The validation check
undertaken here uses a dataset compiled using a similar methodology. This information can be used to
construct a variable that indicates whether tax sheltering activity was alleged in any given firm-year.
Specifically, let the indicator variable it be equal to one if firm  was alleged to have used a tax shelter in
year , and zero otherwise. This variable is merged with data on the book-tax gap and a set of control
variables from the merged Compustat-Execucomp dataset, in order to examine the relationship
between involvement in tax shelter litigation and book-tax gaps. The regression specification used is:
    h|  
h
 
#  V

 

 (1)
where Ki and t are firm and year fixed effects, respectively, and $it is the error term. 'it is a vector of
control variables that includes measures of firm size (assets, sales and market value) and the structure
of executive compensation.
The resulting sample is very small ʹ there are only 14 firms that were involved in tax shelter litigation at
some point in the sample period, and for which all the required data is available. Nonetheless,
estimating Equation (1) using this sample results in a positive coefficient on Lit, as reported in column 1
of Table 2; i.e. the book-tax gap for a given firm tends to be larger in years when that firm is allegedly
using tax shelters, relative to the book-tax gap for the same firm in other years. This result is driven
entirely by within-firm variation in Lit, controlling for time-specific changes in sheltering activity.
Unsurprisingly, this result is of borderline statistical significance, given the small sample size. Column 2
reports the same specification using all available observations in the merged Compustat-Execucomp
dataset; the estimate of 1 is very similar in magnitude to that in Column 1.10
$304: rook-Tax Gaps and Tax Shelter Litigation
Dependent Variable rook-Tax Gap
(1) (2)
Firms Involved All Firms
in Tax Shelter
Litigation
Indicator (M1) for Alleged Tax Shelter Activity 0.0222* 0.0190
(0.0124) (0.0125)
Accruals Measure (Scaled) 0.0440** 0.3646**
(0.0200) (0.0574)
Controls for Changes in Sales, Assets, Market Value, and the Ratio of Y Y
the Value of Stock Option Grants to Total Compensation for Top 5
Executives?
Year and Firm Effects? Y Y
No. of Firms 14 1,600
No. of Obs. 80 6,799
R-Squared 0.5258 0.5005
: The dependent variable is the book-tax gap, as defined in Section III. The indicator variable of interest M 1, the sample is
restricted to those firms in the tax shelter litigation dataset. In Column 1, the sample is restricted to those firms in the tax
shelter litigation dataset. In column 2, the sample includes all firms in the merged Compustat and Execucomp databases for
which the required data is available. IN each case, the sample period is 1992-2001. The specifications include year effects, firms
fixed effects and the set of controls specified. Robust standard errors that are clustered at the firm level are presented in
parantheses; *,** and***denotes significance at the 10 percent, 5 percent and 1 percent levels, respectively.
Any conclusions from this validation check are necessarily tentative, given the small number of firms
that have been involved in tax shelter litigation. Nonetheless, it appears that the measure of tax
avoidance employed below captures a critical element of tax sheltering activity, as it takes on higher
values for those firm-years for which there is some independent evidence for alleged tax shelter activity.
 ã¢
    
While the central hypothesis of the paper concerns the interaction of government institutions and tax
avoidance activity, the question of whether tax avoidance tends to be associated with increases or
decreases in firm value is also of considerable interest. This is addressed using the following
specification:
$   h|  
h
 
#  V

 

 (2)
where the variables rit and it are as defined above, ʅi and ɸt are firm and year fixed effects,
respectively, and ʆit is the error term (note all regressions reported here use both firm and year fixed
effects).
Xit is a vector consisting of the following control variables. Changes in firms size over time are controlled
for using sales. The value of stock option grants to executives as a fraction of total compensation is
included for the reason that a substantial literature finds stock-based compensation to be a determinant
of firm value, presumably through incentive-alignment effects. In addition, the structure of executive
compensation plays a central role in Desai and Dharmapala. To control for changes over time in the risk
associated with a firm͛s stock price a measure of volatility is also included. As net operating loss (NOL)
carryforwards are not taken into account in the measure of tax avoidance (and for the reason that NOLs
can affect the incentives to engage in tax avoidance), NOL carryforwards scaled by assets (with missing
values treated as zeroes) are also included.
If a tax avoidance measure is restricted to domestic Tanzanian tax expense and Tanzanian Federal taxes,
but liabilities and the incentives for tax avoidance may be influenced by foreign activity under the
Tanzanian system of worldwide taxation. Thus, a proxy for foreign activity ʹ the absolute value of
foreign income or loss is included in Xit. As tax shields can affect the value of engaging in tax avoidance,
changes in firms͛ leverage are controlled for by including measures long-term debt and debt in current
liabilities. Changes in intangibles that affect q but are imperfectly measured in the book value of assets
are proxied for by research and development (R&D) expenditures. A number of additional control
variables are used in robustness checks, as described below. Note also that for the reason that firm fixed
effects are employed in the specification described below, many of the sources of cross-sectional
variations in  across firms that have been discussed in the literature are effectively controlled for here.
The specification used to test whether the valuation of corporate tax avoidance is dependent on firm
governance extends Equation (2) as follows:
$   h|  
h
 
h  
h /       
# V

 

 (3)
where Oit is the measure of institutional ownership defined above. The hypothesis is section 2 implies
that ɴ4>0: i.e., the effect of tax avoidance on q is greater in firm-years in which institutional ownership id
higher (and governance is stronger).
The results using OLS estimation on Equations (2) and (3) are reported in Table 4.3; note that all results
reported in this unit use robust standard errors that are clustered at the firm level. Column 1 presents
the results from the estimation of Equation (2). The overall effect on firm value of the proxy avoidance is
positive, but insignificant. The test of the hypothesis using Equation (3) is reported in Column 2. Here,
the coefficient on the interaction term (Oit*rit)ʹ 4 in Equation (3)ʹis positive, consistent with the
hypothesis, and is of borderline statistical significance. The intuition can be reinforced by running (2)
separately for firm-years with high and low levels of institutional ownership (Columns 3 and 4,
respectively), where ͞high͟ institutional ownership is defined as being a fraction that exceeds 0.6, which
is approximately the mean of the sample. For well-governed firm-years, the effect of tax avoidance on 
is positive and of borderline significance. For less well-governed firm-years (with institutional ownership
below 0.6), the effect is also positive, but statistically insignificant, and considerably smaller in
magnitude. Thus, while the estimated overall effect of tax avoidance on firm value is indistinguishable
from zero, the effect appears to be more positive for well-governed firm-years than for poorly-governed
firm-years. This finding is consistent with the hypothesis that agency problems mitigate the benefits to
shareholders of corporate tax avoidance.
$306: Tax Avoidance, Firm Value and Government Institutions: OLS
Dependent Variable Tobin͛s 
(1) (2) (3) (4)
All Firms All Firms Firm-Years Firm-Years
 with High with Low
Institutional Institutional
Ownership Ownership
rook-Tax Gap (Scaled) 0.5776 ʹ2.1655 2.7624* 0.2718
(0.5590) (1.4957) (1.5394) (0.3678)
rook-Tax Gap Interacted with 5.6687*
Institutional Ownership
(3.3307)
Institutional Ownership 0.7706**
(0.3287)
Total Accruals (Scaled) 1.3267** 1.2689** 0.5313 1.1159*
(0.3811) (0.3613) (0.5676) (0.5892)
Ratio of Value of Stock Option Grants to 0.4391** 0.4371** 0.5627** 0.2253
Total Compensation for Top 5 Executives (0.1208) (0.1202) (0.2004) (0.1745)
Sales 0.0442* 0.0471* 0.0195 0.0592
(0.0249) (0.0250) (0.0158) (0.0404)
Volatility ʹ2.114006** ʹ1.9465** ʹ3.8771** ʹ1.0303*
(0.6682) (0.6466) (1.2553) (0.5697)
Controls for Tax Shields (NOLs, Long-term Y Y Y Y
Debt, and Current Debt)
Controls for Foreign Income/Loss and Y Y Y Y
R&D
Year and Firm Effects? Y Y Y Y
No. of Firms 862 862 583 614
No. of Obs. 4,492 4,492 2,324 2,168
R-Squared 0.6483 0.6500 0.7765 0.6213
: The dependent variable is Tobin͛s q, as defined in Section III. The sample (over the period 1993-2001) is drawn from the
merged Comustat and Execucomp databases, and is restricted to those firm-years for which CDA/Spectrum data on institutional
ownership is available. All specifications include year effects, firm fixed effects and the controls listed. In column 3, the sample
is restricted to firm-years with institutional ownership>0.6. In column 4, the sample is restricted to firm-years with institutional
ownership ч0.3. Robust standard errors that are clustered at the firm level are presented in parentheses; *, ** and *** denote
significance at the 10 percent, 5 percent and 1 percent levels, respectively.
 
 A9

$ ¢
    
" ¢ 
OLS estimation of Equations (2) and (3) gives rise to two types of potential problems. The first is
measurement error in the proxy for tax avoidance, particularly if the extent of measurement error
differs by governance institutions. For example, if the proxies used for earnings management are
incomplete, then the remaining component of the book-tax gap may be mischaracterized as tax
avoidance when it actually represents earnings management. Accordingly, it is possible that the results
are driven by differential market reactions to earnings management by well-governed and poorly-
governed firms. The second is the potential endogeneity of tax avoidance activity. For example, firms
that are performing worse for other reasons may be more likely to engage in tax avoidance.
In order to address these concerns, an exogenous source of variation in firms͛ opportunities for tax
avoidance is required. Fortunately, a 1997 regulatory change with unrelated objectives lowered the
costs of tax avoidance for a subset of firms. In late 1996, the Treasury issued what are known as the
͞check-the-box͟ (CTr) regulations. These regulations enable firms to choose their organizational form
for tax purposes ʹ for example, whether to be taxed as a Corporation or as a pass-through entity such as
a partnership or sole proprietorship ʹ by filing a one-page form on which they could simply check the
appropriate box. In replacing a complex set of rules by which the IRS determined firms͛ tax status, the
CTr regulations were intended to reduce the administrative burdens faced by small firms. Researchers
studying international taxation argue that the CTr regulations also had the unintended consequence of
facilitating tax avoidance by large US-based multinational firms through the use of what are known as
͞hybrid entities͟ (see in particular Altshuler and Grubert (2005)). Hybrid entities are classified in two
distinct ways ʹ as separately incorporated subsidiaries under the tax rules of one country and as
unincorporated branches under the tax rules of another country.
The instruments for tax avoidance involve interacting a dummy variable for the post-CTr time period
(i.e. the years since 1997) with firm-year-level variables that capture the incentive to engage in tax
avoidance. The central idea underlying the identification strategy is that, for a given incentive to engage
in tax avoidance, a firm will engage in more actual tax avoidance after the CTr regulations were adopted
than it would have before, other things equal. A crucial determinant of the incentives to engage in tax
avoidance is the availability of ͞tax shields͟ (i.e. tax deductions from other sources, such as interest
deductions or NOL carryforwards resulting from losses in previous years); for instance, Graham and
Tucker (2006) emphasize the substitutability of tax shelters and other kinds of tax shields. Instruments
for tax avoidance can thus be constructed by interacting a dummy variable for the period after the CTr
regulations with each of the following variables: NOL carryforwards and two different measures of debt
(long-term debt and debt in current liabilities).
$303: rook-Tax Gaps, Tax Shields, and the ͞Check-the -rox͟ Regulations: First-Stage IV Results
Dependent Variable rook-Tax Gap
(1) (2)
PostCTr*(NOL Carryforwards) ʹ0.0349** ʹ0.0162
(0.0139) (0.0356)
PostCTr*(Long-Term Debt) ʹ0.0127 ʹ0.0474
(0.0160) (0.0384)
PostCTr*(Current Debt) ʹ0.0879* ʹ0.3103**
(0.0507) (0.1197)
PostCTr*(NOL Carryforwards)*(Institutional ʹ0.0579
Ownership) (0.1197)
PostCTr*(Long-Term Debt)*(Institutional Ownership) 0.0548
(0.0570)
PostCTr*(Current Debt)*(Institutional Ownership) 0.4149**
(0.1644)
F-statistic for Joint Significance of the Instruments (P- 3.33* 3.00***
value) (0.0189) (0.00063)
Controls for Total Accruals, Executive Compensation, Y Y
Sales, Volatility, Foreign Income/Loss, and R&D
Controls for Tax Shields (NOLs, Long-term Debt, and Y Y
Current Debt)
Control for Institutional Ownership N Y
Year and Firm Effects? Y Y
No. of Firms 862 862
No. of Obs. 4,492 4,492
R-Squared 0.5993 0.6009
: The dependent variable is the book-tax gap, as defined in the text. ͞PostCTr͟ is an indicator variable for years after the
͞Check-the-box͟ regulations were introduced (1997-2001). The sample (over the period 1993-2001) is drawn from the merged
Compustat and Execucomp databases, and is restricted to those firm-years for which CDA/Spectrum data on institutional
ownership is available. All specifications include year effects, firm fixed effects and the controls listed. Robust standard errors
that are clustered at the firm level are presented in parentheses; *, ** and *** denote significance at the 10 percent, 5 percent
and 1 percent levels, respectively.
The IV approach involves instrumenting for the endogenous variable rit in Equation (2) using as the set
of instruments the variables listed above, each interacted with a dummy variable for the post-CTr
period. Let Pt be the dummy for the post-CTr period, `R it be the `R carryforwards for firm  in year ,
 it be long-term debt for firm  in year , and it be debt in current liabilities for firm  in year . Then,
the instruments for rit are (t*`R it), (t* it), and (t*it). The first-stage regression (reported in
Column 1 of Table 4) shows that these instruments are indeed strongly related to rit. Specifically, the
coefficients are negative, as expected; i.e. lower values of tax shields (which imply a greater incentive to
engage in tax avoidance) are associated with larger values of rit after the CTr regulations than before,
controlling for other factors. The instruments are jointly significant at the 5 percent level. In Equation
(3), there are effectively two endogenous variables ʹ rit and (Oit*rit) ʹ and the set of instruments thus
includes interactions with Oit. In particular, the instruments for rit and (Oit*rit) are the following:
(t*`R it), (t* it), (t*it), (Oit*t*`R it), (Oit*t* it), and (Oit*t*it). The first-stage results (presented
in Column 2 of Table 4) show the expected negative relationship between each of the first three of these
instruments and rit; the full set of instruments is also strongly jointly significant.
The basic rationale for this IV approach is that a given incentive to engage in tax avoidance should lead
to more actual tax avoidance after the CTr regulations than before. The crucial exclusion restriction
underlying the use of these instruments is the following. The underlying tax shield variables (`R s and
the debt measures) used in constructing the instruments may directly affect firm value; this direct effect
is controlled for by including the tax shield variables in the specification. Nevertheless, the tax shield
variables should not affect firm value differently after the CTr regulations, other than through their
influence on incentives for tax avoidance. This restriction is conditional on the controls included in the
model: for example, even if firm valuations were in general higher in the late 1990͛s, the year dummies
included in the specification would account for this. Of course, the validity of the exclusion restriction
depends on there being no other changes over time in the effect of the tax shield variables on firm
value. To test for possible violations of this exclusion restriction, interactions between the tax shield
variables and time trends are included in the model as a robustness check.
" 


The second-stage results from the IV analysis are presented in Table 5. Column 1 reports the results
from estimating Equation (2), using the instruments for rit described above. The overall estimated
effect of tax avoidance on firm value is substantially larger than in the OLS results in Table 3. Column 2
reports the results from estimating Equation (3), using the instruments for rit and (Oit*rit) described
above. The coefficient ɴ4 of the interaction between governance and tax avoidance is positive and
highly significant, consistent with the paper͛s main hypothesis. The IV results thus support the notion
that the benefits to shareholders from corporate tax avoidance depend on firms͛ governance
institutions.
$301: Tax Avoidance, Firm Value and Government Institutions: Second-Stage IV Results
Dependent Variable Tobin͛s  Tobin͛s  Market Tobin͛s 
Value
(Scaled)
(1) (2) (3) (4)
rook-Tax Gap (Scaled) 14.523 ʹ5.8710 ʹ6.9313 ʹ4.2465
(12.288) (5.1474) (4.9001) (4.0640)
rook-Tax Gap Interacted with Institutional 32.8204** 31.4461** 21.4885**
Ownership (13.0267) (12.8540) (10.8603)
Institutional Ownership 1.0331** 1.0593** 0.9614**
(0.4376) (0.4250) (0.3976)
Total Accruals (Scaled) ʹ2.8305 ʹ1.3588 ʹ0.4447 ʹ0.2585
(3.6467) (2.3935) (2.3651) (1.8085)
Ratio of Value of Stock Option Grants to 0.3495 0.4839** 0.5532** 0.4732**
Total Compensation for Top 5 Executives (0.3092) (0.2142) (0.1919) (0.1609)
Sales 0.0434 0.0473* 0.0581 0.0418
(0.0276) (0.0264) (0.0245) (0.0255)
Volatility ʹ1.0221 ʹ1.2096 ʹ1.2202 ʹ1.5364**
(0.9795) (0.7703) (0.7869) (0.7227)
Controls for Tax Shields (NOLs, Long-term Y Y Y Y
Debt, and Current Debt)
Controls for Foreign Income/Loss and R&D Y Y Y Y
Interactions between Tax Shield Variables N N N N
and Time Trends
Year and Firm Effects? Y Y Y Y
No. of Firms 862 862 862 862
No. of Obs. 4,492 4,492 4,470 4,492
: The dependent variable in Columns 1, 2 and 4 is Tobin's q , as defined in Section III. The dependent variable in Column 3
is market value (scaled by the book value of assets), as defined in Section V. The sample (over the period 1993-2001) is drawn
from the merged Compustat and Execucomp databases, and is restricted to those firm-years for which CDA/Spectrum data on
institutional ownership is available. All specifications include year effects, firm fixed effects and the controls listed. The book-tax
gap variable and the interaction between the book-tax gap and institutional ownership are instrumented, as described in the
text. Robust standard errors that are clustered at the firm level are presented in parentheses; *, ** and *** denote significance
at the 10 percent, 5 percent and 1 percent levels, respectively.
The results in Table 4.5 are in the same direction as the OLS results in Table 3, but are considerably
stronger. The coefficients from Tables 4.3 and 4.5 can be interpreted as reflecting an expected duration
of a particular tax shelter or the ability to engage in tax planning for a given period. Suppose a firm
unexpectedly increases its book-tax gap by $1. The current-year tax benefit (including federal and state
tax benefits) would be approximately $0.40. Market reactions are given by the coefficient on the book
tax gap and should incorporate an expectation of how long tax sheltering activity will continue in the
future. Using reasonable discount rates, the estimated coefficient (2.76) for the well-governed sample in
the OLS specification (column 3 of Table 3) would correspond to an expected life of tax savings of seven
to nine years for well-governed firms. Nevertheless, interpreting this OLS coefficient in this manner is
intricate by the identification concerns discussed above and the marginal significance of the coefficient
in Table 4.3.
The IV estimate in column 3 of Table 4.5 can be used to overcome these complexity. Taking a firm with a
mean value of institutional ownership, these coefficients entail that the market interprets an increase in
the book-tax gap as a quasi-permanent change in tax obligations. As such, changes in the book-tax gap
are not interpreted as momentary items associated with particular shelters but as signals of general tax
planning ability. The bigger effects using the IV approach suggest that measurement error in the tax
avoidance proxy may lead to attenuation bias in the OLS estimates. Alternatively, the OLS estimate of
the effect of tax avoidance on firm value may be biased towards zero by the form of endogeneity noted
above, where firms that are performing poorly for other reasons are more apt to engage in tax
avoidance.
 
    " 


These IV results come out to be robust to concerns regarding the measurement of the booktax gap,
governance, and firm value. For example, the basic result in Column 2 of Table 4.5 is robust to the
(unreported) inclusion of additional variables ʹ particularly, deferred tax expense, depreciation expense,
investment tax credits, interest expense, pension expense, and a proxy for employees͛ stock option
exercises - that control for the potential mismeasurement of the booktax gap. It is also robust to adding
lagged tax prevention activity to the model; this does not change the effect of that period tax avoidance
(interacted with Oit), and the effect of the lagged variable is small and insignificant. Thus, there is no
evidence to suggest a substantial delayed market reaction to firms͛ tax avoidance activity.
The consequences are also robust to using alternative actions of governance. Specially, the findings are
unaffected when Oit is replaced by the index of antitakeover provisions constructed by Gompers et al.
(2003). This index represents a count of antitakeover provisions that apply to a firm (either through its
corporate charter or state law). It takes on values up to 18, with lower values representing better
governance. As the cardinal properties of this index are unclear, the robustness check involves
constructing an indicator variable for better-governed firms by dividing the sample at the mean (with
values of 9 or lower corresponding to ͞well-governed͟ firms). The interaction between this indicator
variable for well-governed firms and rit is very similar in magnitude and significance to that in Column 2
of Table 5. This suggests that the results are robust to alternative notions of governance, as the
Gompers et al. (2003) index measures managerial entrenchment rather than the quality of monitoring.
Moreover, this also indicates that the results are unaffected by the potential endogeneity of Oit, where
institutional investors may choose to buy firms that are expected to increase in value; this is less
applicable to the Gompers et al. index, as its values were predominantly determined in the 1980͛s, and
generally do not change during the sample period.
While the baseline condition in Table 4.5 comprises an extensive set of controls, it is probable that
unobserved changes in firms͛ investment opportunities or anticipated future performance may affect .
To address these concerns, it is probable to comprise capital expenditures and future revenue growth as
additional controls; together with these controls leads to consistent results. In addition, although
Tobin͛s q is a standard measure of firm value in the literature, it is however significant to consider
alternative proxies. As  takes account of the book as well as market value of equity and the value of
debt, a simpler measure is the market value of common stock (Execucomp variable MKTVAL, the closing
share price for the fiscal year multiplied by the number of common shares outstanding). This is scaled by
the book value of assets in order to be conventional to the scaling of the independent variables. As
exposed in Column 3 of Table 5, using this variable instead of  leads to basically identical results.
In conclusion, the identification strategy used above depends on the validity of the exclusion
restrictions. In particular, it necessitates that there are no changes over time in the effect on firm value
of the tax shield variables that are used in constructing the instruments (other than the change due to
the impact of the CTr regulations on tax avoidance activity). This postulation may be violated if there
are trends unrelated to the CTr regulations in the effect of the tax shield variables on q. It is possible to
test for this possibility by adding to the model interactions between a time trend and each of the tax
shield variables. Particularly, these additional control variables are (`R it*( ʹ 1997)), ( it*(t ʹ 1997)),
and (it*( ʹ 1997)), where is the year (1997 ʹ which is the midpoint of the sample period ʹ is used as
the base year). The second-stage IV results with the addition of these controls are presented in Column
4 of Table 4.5. While the coefficient of the interaction term of interest is to some extent smaller, it
remains significant at the 5 percent level. Thus, it does not appear that the effect of the instrumental
variables is driven by time trends in the impact of the tax shield variables on firm value. Fairly, the
results seem to depend only on the sporadic change in the effect of tax shields on firm value that is
connected with the CTr regulations.

The simple belief that corporate tax avoidance symbolizes a transfer of value from the state to
shareholders does not appear to be validated in the data. Rather, the patterns in the data are more
regular with the agency perspective on corporate tax avoidance, which emphasizes the mediating role of
governance. The basic result that higher quality firm governance leads to a larger effect of tax avoidance
on firm value is toughened by using an exogenous source of variation due to changes in tax regulations
to build instrumental variables for tax evading activity. The results are robust to a wide variety of tests
for alternative explanations. Furthermore, the magnitude of the effect entails that changes in the book-
tax gap are interpreted by the market as signals of overall tax preparation ability for well-governed
firms, rather than simply reflecting the use of particular tax sheltering strategies.
c.ã!E¢ã;#"ããh . ¢A  " " ¢¢* 
Generally, CAPM provides a natural theory to determinate the market price for risk and the suitable
measure of risk. This model was developed more or less at the same time by Sharpe (1963-1964) and
Treynor (1961), and Mossin (1966), Lintner (1965-1969) and rlack (1972) developed it further. This
model show that the equilibrium rates of return on all risky assets are function of their covariance with
the market portfolio. rut CAPM has a lot of implications for some corporate policy decision. So, the cost
of equity capital for a firm is given directly by CAPM. After all, the company's beta is measured by
calculating the covariance between the return on its common stock and the market index.
Consequently, the beta measures the systematic risk of the common stock, and if we know the
systematic risk, we can use the CAPM to determine the require rate of return on equity. Equation (4) is
known as the capital asset pricing model, CAPM:
1
 0 !2
1  & 0  (4)
where:
S(Ri) M the expected rate of return on asset ;
RF M the risk-free rate (constant);
S(RM) M the expected rate of return on the market portfolio.
It is shown graphically in fig.1, where it is also called the security market line. All securities fall exactly on
the security market line. The required rate of return on any asset, S(Ri) in eq (4), is equal to the risk-free
rate of return plus a risk premium. The risk premium is the price of risk multiplied by the quantity of risk.
In the terminology of the CAPM, the price of risk is the slope of the line, the difference between the
expected rate of return on the market portfolio and the risk-free rate of return. The quantity of risk is
often called beta, ɴi.


*  3
3 * 

(5)

* 
*

S(Ri)

Security Market Line

S(RM)

RF

ɴi M 1
 h

30 
¢ *


 
It is the covariance between returns on the risky asset, , and market portfolio, M, divided by the
variance of the market portfolio. The risk-free asset has a beta of zero for the reason that its covariance
with the market portfolio is zero. The market portfolio has a beta of one for the reason that the
covariance of the market portfolio with itself is identical to variance of the market portfolio:
 3 *
3 *  
*
*
| (6)

* *
13
&3 0
The Slope M 13 * &3 0 (7)


is definition for the price of risk.
If it is possible to estimate the systematic risk of a company's equity as well as the market rate of return,
then S(Ri) is the required rate of return on equity, i.e., the cost of equity for the firm. If we designate the
cost of equity as Rc, then:
13
 3  (8)
When we combine CAPM with the cost of capital definitions derivated by Modigliani and Miller Theory
(1958-1963), it provides a unified approach to the cost of capital.
Figure 4.2 illustrates the difference between the original Modigliani-Miller cost of capital and the CAPM.

h

304  




MM assumed that all projects within the firm had the same business or operating risk. Consequently,
the WACC in the MM theory, is represented by the horizontal line in fig. 4.2. The WACC for the firm does
not change as function of systematic risk. This assumption, of course must be modified for the reason
that firms and projects differ in risk.
Table 6 shows expressions for the cost of debt before taxes,
, unlevered equity, Rc(N), levered equity,
Rc(O) , and weighted average cost of capital, WACC, in both the MM and CAPM frameworks.

@able 4.6: Comparison of MM and C M Cost of Capital Equations

Type of cost of capital CAPM Definition MM Definition
Interest rate rM RF+ɴd(RMʹRF) rMRF; ɴd M 0
The cost of equity for the Rc(N)MRF + ɴ(N) (RMʹRF) Rc(N)M Rc(N)
unlevered firm
The cost of equity for the Rc(I) M RF + ɴ(I) (RMʹRF) §
Rc(I) M Rc(N) + (1ʹT) (Rc(N)ʹr).
levered firm
WACC §
WACC(I)MRc(I)+r(1ʹT). ା§
WACC(I) M Rc(N).[1ʹT. ା§
]
Now we will demonstrate, that the traditional and MM definition of WACC (the last line in table 1) are
identical.
ry definition:
4 5
6¢44  4  ! 0 |#@ (9)
4!5 4!5
Substitute into the right hand side the CAPM definition of the cost of levered equity, Rc(I), from (10):
5
     !|#@ 7 # 0  (10)
4
We have:
4 5 4 5 4
6¢44  7  ! 47 |#@  # 0 |#@  !
4!5 4 4!5 4 4!5
(11)
5  4 5   @5 
! 0 |#@  7 !|&@
5 47 |&
4!5  4!5 4!5   4!5

Modigliani-Miller assumed, for convenience, that corporate debt is risk free; i.e., that its price is
sensitive to changes in interest rates and either that it has no default risk or that default risk is
completely diversifiable (ɴd M 0).
The Modigliani-Miller definition of the cost of equity for the unlevered firm was tautological, i.e., Rc(N) M
Rc(N), for the reason that the concept of systematic risk had not yet been developed in 1958. We know
that it depends on the systematic risk of the firm͛s after-tax operating cash flows, ɴ(N). Unfortunately for
empirical work, the unlevered beta, ɴ(N), is not directly observable. We can, nevertheless, easily estimate
the levered equity beta, ɴ(I). To derive the relationship between the levered and unlevered betas, begin
by equating the Modigliani-Miller and CAPM definitions of the cost of levered equity (line 3 in table 6).

 0 !2    & 0   47 !|&@ 47 &

5
(12)
4
Next, use the simplifying assumptions that rMRF, to write:

 0 !2    & 0   47 !|&@ 47 0 

5
(13)
4
Then substitute into the right-hand side the CAPM definition of the cost of unlevered equity, RC(N),

 0 !2    & 0   !h 7   & 0 !|&@ 0 ! h 7  & 0& 0

5
(14)
4
ry cancelling terms and rearranging the equation, we have:

2    & 0 2 7   & 0 !|&@2 7   & 0

5
(15)
4

 5
2   & 0 2 7  & 0  |!|&@
(16)
 4
 5
2  2 7 |!|&@
(17)
 4
The implication of eq. (17) is that if we can observe the levered beta by using observed rates of return
on equity capital in the stock market, we can estimate the unlevered risk of the firm͛s operating cash
flows.
To obtain the graph in which is shown changes in the cost of capital in function of leverage increase,
begin by eq. (11)
 @   & 
6  3 
 |&
3 
 |&@
    

 
 4   | 
 47 & 47 @  |&   47 & 47 @  |& 5 
4!5   |! 
4
|
 47 |&@! 47 @ (18)
5
|!
4
5
For ? Õwe will obtain 6¢44
 8 47 |&@
4

Fig. 4.3. Changes in the cost of capital as leverage increases

Note that the cost of equity increases with increasing leverage. This simply reflects the fact that
shareholders face more risk with higher financial leverage and that they require a higher return to
compensate them for it. A more difficult problem is to decide what to do if the project's risk is different
from that of the firm. In this case, the cost of capital must be risk-adjusted for capital budgeting
purposes. Each project must be evaluated at a cost of capital that reflects the systematic risk of its
operating cash flows as well as the financial leverage appropriate for the project. Estimates of correct
opportunity cost of capital are derivated from a through understanding of the Modigliani-Miller cost of
capital and the CAPM.
#"ãh¢*¢ :#ã!;"r
In most cases the debt is not free of risk. rut, in simple discussions when we talk about the weighted
average cost of capital (WACC), we take the debt for risk-free. At the same, in the calculation of the
WACC, we may use a value for the cost of debt  that is higher than the risk-free rate rf. In assuming that
the debt is risk free, there are several advantages.
! First, when we assume that the debt is risk-free, we do not have to model the risk of default on
the debt.
 ! Second, with risk-free debt, the expected return on the debt is equal to the promised return and
we do not have to distinguish between the expected return on the debt and the promised
return.
! Third, since the debt is risk free, the cost of debt is constant and not a function of the amount of
debt. Thus, we do not have to model how the cost of debt d varies as a function of the amount
of debt D.
Taxes raise additional complications. With risky debt, we have to use the expected rate of return on the
debt rather than the promised rate of return on the debt in the formula for the WACC. Furthermore, we
model the expected cost of debt risky as an increasing function of the amount of debt.
Here we will examine the probability of risk in both single period binomial model and multi-period
model.
ã
*

r

 
We start by reviewing the standard formula for the WACC. In words, the WACC is a weighted average of
the market cost of debt and the return to equity, where the weights are the market values of the debt
and equity, as percentages of the total value.
WACC M percentD*d + percentE*e
(19)
Where d is the market cost of debt,
e is the return to equity,
percentD is the market value of debt as a percent of the total value and
percentE is the market value of equity as a percent of the total value.
ã
*

r

 
We briefly review the single period binomial model. Consider a simple one period binomial model with
two states of nature. Let FCF(i,j) be the value of the FCF in the jth state of the ith year. In the up state of
nature, the value of the FCF is TZS 190 and the down state of nature, the value of the FCF is 50.
FCG(1, 1) M (20)
FCF (1,2) M (21)
We assume that both states of nature are equally likely. Let P be the set of probabilities for two states of
nature, where pU is the probability of the up state of nature and (1ʹpU) is the probability of the down
state of nature.
Let Ep{ECF(1, 1:2)} be the expectation of the FCF for the two states of nature in year 1, with respect to P.
The expected FCF is TZS120.
Ep{FCF(1, 1:2)} M pU*FCF(1, 1) + (1 ʹ pU)*FCF(1, 2)
M 50 percent *190 + 50 percent *50 M 120.00
(22)
We assume that the return to unlevered equity ʌ is 20 percent . Thus, with respect to year 0, the
(present) value of the FCF, discounted with ʌ, is TZS100.
 9040||
: |

' c    |  (23)
|!; |!
Ë
"%
 
$$


 (

A 

$$


 )
We can calculate the value of the FCF with respect to year 0 in another equivalent way. Rather than
using the set o probabilities P, we define another set of equivalent probabilities Q M (qU, (1 ʹqU)). The set
of equivalent probabilities Q (also known as risk-neutral probabilities), unlike the set of probabilities P,
are very useful for the reason that they are appropriate (and convenient) for taking the expectation of
any cash flow structure.1
To find the value of ECF, we take the expectation of the ECF with respect to Q and discount with the risk-
free rate rf. Assume that the risk-free rate is 12 percent . We verify that the appropriate value of qU is
44.29 percent .
Let EQ{FCF(1, 1:2)} be the expectation of the FCF for the two states of nature in year 1, with the respect
to Q. The expected FCF is TZS112.
 9040||
:  c 040|| ! |& c 040|

(24)
//
XË|X !|#//
XË ||

Thus, with respect to year 0, the (present) value of the FCF, discounted with rf, is TZS100.
 9040||
: ||

' c    |  (25)
|! |!|
Ë
$h
 

Next, we introduce debt financing. Let X(1) be the total payment (principal interest) for the debt in year
1 and let D(0) be the value of the debt in year 0. The maximum amount that can be repaid in year 1, with
no risk, is equal to the value of FCF(1,2). That is,
D(0)*(1 + rf) M FCF(1,2) (26)
Solving for D(0), we obtain:
040
 
5     //</ (27)
|! |
|
Ë
The critical value of the debt is TZS 44.64. If the value of the debt at the end of year 0 is higher than
$44.64, then there is a positive probability of default and the cost of debt will be higher than the risk-
free rate of 12 percent .
For example, suppose the project ͞promises͟ to pay X(1) to the debt holder at the end of year 1, where
the value of X(1) is TZS60. At the end of year 0, what is the market value of debt? Let CFD(I, j) be the
cash flow to debt (CFD) in the jth state of nature in the ith year. If the up state of nature occurs, there
will be no problem in making the payment of TZS to the debt holder. Nevertheless, if the down state of
nature occurs, then the debt holder simply receive TZS50, which is the value of the FCF, and the equity
holder will receive nothing.
CFD(1, 1) M 60 (28)
CFD(1, 2) M 50 (29)
To find the market value of the debt, we take the expectation of the CFD with the risk-neutral
probabilities and discount with the risk-free rate.

1
There are two equivalent ways to calculate the value of an expected cash flow. First, we take the expectation of
the cash flow with respect to a set of probabilities P and discount with the risk-adjusted discount rate. Second, we
take the expectation of the cash flow with respect to Q, which is an equivalent set of probabilities, and discount
with the risk-free rate. In terms of valuation, it is more convenient to take expectation with respect to the set of
risk-neutral probabilities Q rather than the set of probabilities P.
Since the risk-free rate is lower than the risk-adjusted rate, in the alternative method, the expectation of the cash
U
flow has to be lowered accordingly by decreasing the probability for the up state of nature. Thus the value of q ,
U
which is the equivalent probability for the up state of nature, is lower than the value of p , which is the original
probability for the up state of nature. Another way to think of the change in probabilities is as follows. Taking the
expectation with respect to the equivalent set of probabilities Q, we ͞subtract͟ the risk premium from the cash
flow to obtain the certainty equivalent. Consequently, we can discount the certainty equivalent with the risk-free
discount rate.
Let EQ{CFD(1, 1:2)} be the expectation of the CFD for the two states of nature in year 1, with respect to
Q. The expected CFD is TZS54.43.
EQ{CFD(1, 1:2)} M qU*CFD(1, 1) + (1ʹqU)*CFD(1, 2)
M 44.29 percent*60 + (1 ʹ 44.29 percent)*50 M 54.43
(30)
Thus, with respect to year 0, the (present) value of the FCF, discounted with rf, is TZS48.60.
 9405||
: //
5    /=< (31)
|! |!|
Ë
The value of the debt is 48.60 percent of the total value of TZS100. relow we show and explain the
calculation for the promised and expected rate of return to debt.
*


 

  $
Since the debt is risky, we distinguish the promised rate of return on the debt dProm from the expected
rate of return on the debt dExp. In the calculation of the WACC we use the expected rate of return on the
debt rather than the promised rate of return.
*



$
The promised payment is X(1) and equal to TZS60. The promised rate of return is equal to 23.46 percent.
&| <  &|
     
/<Ë (32)
5  /=<
In the down state of nature, the FCF of TZS50 is less than X(1) and the ͞promise͟ will not be fulfilled.
"

$
The relationship for the expected rate of return to debt is as follows.
 9405||
:   9405||
:
 (33)
|! |! 
The expectation of the CFD in year 1 with respect to Q and discounted with the risk-free rate is equal to
the expectation of the CFD in year 1 with respect to P and discounted with the expected rate of return.
Let EP{CFD(1, 1:2)} be the expected value of the CFD for the two states of nature in year 1, with respect
to P. The expected CFD is TZS55.
EP{CFD(1, 1:2)} M pU*CFD(1,1) + (1 ʹpU)*CFD(1, 2)
M 50 percent*60+50 percent*50 M 55.00
(34)
Solving for the expected rate of return to debt in equation 13 and substituting the appropriate values,
we obtain that the expected rate of return is 13.18 percent.
  9405||
:|! &|
  
 9405||
:
|! |

  |  ||=Ë (35)
//
It can be shown that the expression for the expected rate of return to risky debt is as follows.
$
.  
 &&; (36)
 


%

We can show that in the single period case, if the debt is risky, the rate of return to equity e is constant
and the formula for the return to equity is as follows.
.
  | È   
|
.
  Ë
M |
|
Ë  | Ë 
<//Ë (37)
//
XË
:
 
 

We verify that the values for the cost of debt and return to equity are correct by showing that the WACC
is equal to the return to unlevered equity ʌ.
EACC M percent D*d+ percentE*e
M 48.60 percent*13.18 percent + (1ʹ48.60 percent)*26.44
M 20.00 percent (38)
"

 



 

$
Thus, if the debt is risky, we can use equations 36 and 37 to estimate the cost of the debt as a function
of the value of debt. For example, if the value of the debt in year 0 D(0) is TZS60, then the expected
return on the debt is 15.71 percent

.  
 $ &&;
 
(39)
|
 
<//#
<//#
 |>|
<
To borrow TZS60 at the end of year 0, the project must promise to pay TZS88.84 at the end of year 1,
with a promised return of 48 percent. We verify that these numbers are correct.
EQ{CFD(1,1:2)}MqU*(CFD)(1,1)+(1ʹqU)*CFD(1,2)
M 44.29 percent*88.84 + (1ʹ44.29 percent)*50 M 67.20
(40)
Thus, with respect to year 0, the (present) value of the CFD, discounted with rf, is TZS60.
$ ) 9||
: <>

  <  (41)
| ||

 


$
  $

5
In the following graph, we plot the relationship between the expected rate of return to debt and equity
versus the value of the debt in year 0. As expected, for values of debt less than or equal to TZS44.64, the
expected rate of return to debt is equal to the risk-free rate of 12 percent. As the value of debt increases
above TZS44.64, the expected rate of return to debt increases, at a decreasing rate.
For values of debt less than TZS44.64, when the cost of debt is constant, the rate of return to equity
increases, at an increasing rate. As the value of debt increases above TZS44.64, the rate of return to
equity is constant.
Graph 1: Relationship between the expected rates of return and the value of debt D(0)
 c A*"r ¢  " 
In this section, we present a four period binomial model and use one-way tables to show the
relationship between the cost of debt and the amount of debt. With a binomial model, we can see
clearly the impact of the passage of time on the expected return to debt and equity. For convenience we
use a recombining tree to represent the (present) value of the FCF rather than the FCF process. Let
VUn(i,j) be the (present) value of the FCF in the jth state of nature in the ith year. We assume that VUn(i,j)
either increases or decreases by 20 percent.
.
 4: Process for the unlevered value VUn(i,j)

There are no free cash flows in years 1 to 3. The only cash flows occur in year 4.
FCF(i,j) M 0 for all i ч 3 (42)
 FCF(i,j) M VUn(i,j) for i M 4 (43)
For example, under the third state of nature in year 4, the equity holder receives TZS92.16.
You can easily verify that the correct values of the parameters for the above unlevered value process are
as follows.
P M {pU, (1ʹpU)} M {70 percent,30 percent}
(44)
Q M {qU, (1ʹqU)} M {62.5 percent, 37.5 percent}
(45)
Unlevered return ʌ M 8 percent (46)
Risk-free return rf M 5 percent
(47)
$h
 
()
Let X(4) be the payment to the debt holder in year 4. There are no cash flows to debt in years 1 to 3. If
the value of X(4) is less than or equal to TZS40.96, which is the FCF under the fifth state of nature in year
4, then the debt is risk-free and the return to debt is equal to the risk-free rate. If the value of X(4) is
higher than TZS40.96, then the debt is risky for the reason that there is a positive probability that the
debt will not be fully repaid and the return to debt will be higher than the risk-free rate.
Suppose the value of X(4) is TZS60, which is between the values of the FCF under the fourth and fifth
states of nature. With respect to year 0, what is the value of the debt D(0)? To find the value of the debt,
first we calculate the CFE and then the CFD.
In year 4, under each state of nature, the cash flow to equity is as follows:
CFE(4,j) M max{[FCF4(4,j)ʹX(4)],0} (48)
If the FCF is greater than the promised payment for debt, then the CFE is the difference between FCF
and the payment. Otherwise, the equity holder receives zero. The cash flow to debt is simply the
difference between the FCF and the CFE.
relow, we show the process for the value of equity EL(i,j) and the value of debt D(i,j). Under the first four
states of nature in year 4, the FCF is sufficient to pay the debt holder. In the fifth state of nature, the FCF
is insufficient to pay the debt holder.
Under the first four states of nature in year 4, the debt holder receives the promised amount X(4) and in
the fifth state of nature, the debt holder receives the FCF of TZS40.96.
.
 6: Process for the value of (levered) equity EL(i,j) with X(40 M 60)

To find the value at any node in the value trees for the equity and debt, we take the expectation with
respect to the set of risk-neutral probabilities and discount with the risk-free rate rf.
.
 3: Process for the value of debt D(i,j) with X(4) M 60


%
 

$
Next we show the returns to equity and debt at each node of the value trees. The average (expected)
return to equity increases from 10.76 percent in year 0 to 11.72 percent in year 3.
.
 1: Return to levered equity e(i,j) with X(4) M 60

The average (expected) return to debt decreases from 5.13 percent in year 0 to 5.08 percent in year 3.
.
 8: Return to debt D(i,j) with X(4) M 60
We verify that the WACC in year 0, calculated with the expected return to equity and debt, is equal to
the return to unlevered equity ʌ.
WACC(0) M percentD*d + percentE*e
M 49.05 percent*5.13 percent + (1ʹ49.05 percent)*10.76 percent
M 8.00 percent
(49)

 
:
The expectation of the value of the debt at the subsequent two nodes in year 3 with respect to Q,
discounted with the risk-free rate rf is equal to the expectation of the value of the debt at the
subsequent two nodes with respect to P, discounted with d(2,3).
 95/:   95/:

|! |!

c c
  95/: 5!|& 5/
M 70 percent*57.14 + 30 percent*50.34 M 55.10
 95/: c 5!|& c 5/
M 62.5 percent*57.14 + 37.5 percent*50.34 M 54.59
Substituting the appropriate values, we obtain that the expected rate of return on the debt is 5.98
percent.
  9405||
:
5
 |! &|
 9405||
:
| |!Ë
M  |  X=Ë
/X
$
 
(4)
Next we consider a higher level of debt financing. Suppose the value of X(4) is TZS90, which is between
the values of the FCF under the third and fourth states of nature. With respect to year 0, what is the
value of the debt D(0)? Again, we can construct the tree processes for the return to equity and the
return to debt. Under the fourth state of nature in year 3, the return to equity is undefined for the
reason that CFE is less for both the fourth and fifth states of nature in year 4.
.
 7: Return to levered equity e(i,j) with X(4) M 90
With the increase in X(4) from TZS60 to TSZ90, in year 0, the expected return to equity has increased
from 10.76 percent to 13.18 percent and the expected return to debt has increased from 5.13 percent
to 5.80 percent.
.
 F: Return to debt D(i,j) with X(4) M 90

With X(4) equal to TZS90, the reader can verify that the value of the debt in year 0 is TZS70.15.
$
 
(6)
Next, we examine a very high level of debt and set X(4) equal to TZS150, which is between the values of
the FCF under the first and second states of nature.
.
 2: Return to levered equity e(i,j) with X(4) M 150
With such a high level of debt, the CFE will be positive in the first state of nature in year 4 and zero in all
the other states. Now the expected return to equity is constant at 17.60 percent.
.
 5: Return to debt D(i,j) with X(4)M150

For the debt holder, the debt will only be repaid in full under the first state of nature in year 4. Under all
the other states of nature in year 4, the debt holder will receive less than the promised amount. The
expected return to debt is 7.26 percent.
 


$ %

  $

5
In the following graph, we plot the relationship between the expected rate of return to debt and equity
versus the value of the debt in year 0.
Note that when the value of X(4) is between the values of the FCF under the first and second states of
nature, as discussed previously, the expected return to equity is constant at 17.60 percent.
Using the binomial model and a one-way table, we can estimate the expected return to equity and risky
debt as a function of the value of debt in year zero2.

2
It is interesting that numerically we can use the formula for the expected cost of debt for the single period given
in equation 16 to generate the expected cost of debt in the multi-period example. Nevertheless, we have not
attempted to show rigorously that the formula in equation 36 applies in general.
.
 : Relationship between the expected rates of return and the value of debt D(0)

Here we uses simple binomial models to illustrate the WACC with risky debt and no taxes. In the single
period case, when the debt is risk-free, the cost of debt is constant and the return to equity is a function
of the debt-equity ratio. When the debt is risky, the return to equity is constant and the expected return
to debt is a function of the value of debt. In the multi-period case, we use one-tables to show the
relationship between the rates of return to equity and debt as functions of the value of debt in year 0.
#" ¢c;ãcc"h"r
Financial economics has made significant progress in explaining the incentives that lead large public
corporations to choose particular financing policies. Increasingly, the profession is moving beyond an
examination of the basic leverage choice to more detailed aspects of the financing decision. In this
discussion, we extend this literature by employing data from a large sample of firms to examine
hypotheses about the determinants of the maturity structure of the firm͛s debt. We group the
hypotheses that have been offered to explain corporate debt maturity into three categories:
contracting-cost hypotheses, signaling hypotheses, and tax hypotheses. Our evidence supports the
contracting-cost hypotheses. Consistent with Myers (1977), firms with more growth options in their
investment opportunity sets have less long-term debt in their capital structure. Large firms and
regulated firms have more long-term debt. The evidence on signaling hypotheses is mixed. We find
limited evidence that firms use debt maturity to signal information to the market. Nevertheless, our
evidence is consistent with a pooling equilibrium in which firms with larger potential information
asymmetries (measured by the amount of growth options in their investment opportunity sets) issue
more short-term debt. Our evidence also suggests a nonmonotonic relation between credit standing
and debt maturity as predicted by Diamond (1993). We find no evidence that taxes affect debt maturity.
  
$ 


Three nonmutually exclusive sets of hypotheses have been proposed to explain corporate debt
maturity: contracting-cost hypotheses, signaling hypotheses, and tax hypotheses. In this section, we
summarize these basic hypotheses to guide the structure of our empirical tests and the interpretation of
our results.
  
  # 
O
 
 R
 

Myers (1977) argues that a corporation͛s future investment opportunities are like options. The value of
these options depends on the likelihood that the firm will exercise them optimally. With risky fixed
claims in the firm͛s capital structure, the benefits from undertaking profitable investment projects are
capture enough of the benefits so that profitable project does not offer stockholders a normal return. In
these cases, stockholders have incentives to reject positive net present projects. Myers calls this the
underinvestment problem.
With more growth options in the firm͛s investment opportunity set, the conflict between stockholders
and bondholders over the exercise of these options is greater. Myers argues that a firm can control this
incentive problem in several ways: by including less debt in its capital structure, by including restrictive
covenants in its indenture agreements, or by shortening the effective maturity of its debt. Specifically,
Myers notes that if the debt matures before any opportunity to exercise the real investment options,
this disincentive to invest is eliminated. Hence, firms with more growth options in their investment
opportunity sets should employ shorter-maturity debt.
If the firm could costlessly recapitalize itself, this disincentive to invest would be eliminates (Fama 1978).
For example, consider a firm with a growth opportunity that requires an investment in one year. This
firm has the same incentive to invest whether it has one-year debt. This firm has the same incentive to
invest whether it has one-year debt outstanding or ten-year debt that it repays after one year. rut the
recapitalization strategy requires that the firm repurchase its outstanding long-term debt at prices that
do not reflect the value of the new project. If information about the project causes the prices of its long-
term debt to rise, then the benefits from the project are again shared between the stockholders and
bondholdersͶwhether the bonds are repurchased or not Ͷ and the underinvestment incentive
remains. Issuing short-term debt avoids this problem. If fixes the price at which the firm repurchases its
debt and allows stockholders to capture more (if not all) of the benefits from its new investments?
Myers͛ analysis thus provides a rationale for value-maximizing firms to match the effective maturities of
their assets and liabilities. At the end of an asset͛s life, the firm faces a reinvestment decision. Issuing
debt that matures at this time helps to reestablish the appropriate investment incentives when new
investment is required. More importantly, nevertheless, this analysis indicates that the maturity of a
firm͛s tangible assets is not the sole determinant of its debt maturity. The firm͛s intangible assets (its
growth options) play a critical role as well.
Implicitly, Myers must also assume that the cost of rolling short-term debt is greater than the cost of
issuing long-term debt. If there were no differential costs of short-term debt, then all firms would prefer
short-term debt under the contracting-cost hypothesis. The higher costs of short-term debt potentially
include: (1) higher out-of-pocket flotation costs, (2) greater opportunity costs of management time in
dealing with more frequent debt issues, and (3) reinvestment risk and potential costs of illiquidity.
Stulz and Johnson (1985) suggest that the firm can control the underinvestment problem by retaining
the ability to issue fixed claims with high priority (such as secured debt). Financing new investment
projects with high-priority claims limits wealth transfers from stockholders to existing bondholders and
thus reduces the incentives for stockholders to forego these projects. Ho and Singer (1982) argue that
even if short-term and long-term debt have the same priority in bankruptcy, short-term debt has a
higher effective priority outside bankruptcy for the reason that it is paid first. Thus issuing short-term
debt to finance new investment projects offers potential benefits that are similar to those from issuing
secured debt for controlling the underinvestment problem.
Finally, Smith and Warner (1979) hypothesize that risky firms benefit from placing more restrictive
covenants in their debt. Covenants reduce moral- hazard problems (including the underinvestment
problem) that occur after the debt is issued. When a restrictive debt covenant is violated, it is often
optimal to renegotiate the debt agreement rather than forcing the borrower into bankruptcy. The Trust
Indenture Act of 1939, nevertheless, limits the discretion that may be allocated to the trustee in a public
debt issue. It thus is costly to renegotiate covenants in public debt agreements outside the bankruptcy
process. Private lenders, therefore, have a comparative advantage in writing debt contracts with
restrictive covenants. Fama (1985) argues that banks have a comparative advantage over other private
lenders in monitoring such loans. (Consistent with this hypothesis, James (1987) finds a positive and
statistically significant price reaction associated with bank loan announcements, but insignificant price
reactions for public and nonbank private debt announcements.) To maximize the effectiveness of these
monitoring activities, most bank loans are short term. ry reducing the term of the debt, the bank
maintains a stronger bargaining position, and that can affect the firm͛s investment policy. For example,
consider a firm with outstanding public debt that would forego the exercise of a growth option. With
short-term debt, the bank can make exercise of the option a condition for refunding. This suggests that
high-growth firms that choose bank financing over public or nonbank private debt will have more short-
term debt.
á
  
Smith (1986) argues that managers of regulated firms have less discretion over future investment
decisions than managers of unregulated firms. This reduction in managerial discretion reduces the
adverse incentive effects of long-term debt. The contracting-cost hypothesis thus implies that regulated
firms will have longer-maturity debt than unregulated firms.

)

Firm size is potentially correlated with debt maturity for several reasons. Issuance costs for public issues
have a large fixed component resulting in significant scale economies. Smaller firms are less able to take
advantage of these scale economies; they typically opt for private debt with its lower fixed costs and
consequently lower overall costs. Small firms that choose bank debt over public debt for the reason that
of the lower flotation costs will have more short-term debt. Firms with foreign operations are more
likely to issue foreign debt to manage their currency exposure. Many foreign debt markets are less liquid
than U.S. debt markets, especially for longer maturities. Thus, multinational firms are likely to have
more short-term debt. If larger firms are more likely to have foreign operations, this induces a negative
relation between size and debt maturity.
ã


# 

* 
Flannery (1986) and Kale and Noe (1990) examine signaling implications of the firm͛s debt-maturity
choice. The pricing of long-term debt is more sensitive to changes in firm value than the pricing of short-
term debt. Thus, although mispricing of the firm results in both long-term and short-term debt being
mispriced, the mispricing of the long-term debt is greater. If the bond market cannot distinguish
between high-quality and low-quality firms, high-quality (undervalued) firms will want to issue the less
underpriced short-term debt. Low-quality (overvalued) firms will want to issue the more overpriced
long-term debt. Rational investors understand these incentives when valuing risky corporate debt. In
equilibrium, nevertheless, with risky debt of both maturities issued, high-quality firms will issue more
short-term debt and low-quality firms will issue more long-term debt.
 


In addition to a separating signaling equilibrium (in which the firm͛s choice of debt maturity reveals its
type) a pooling equilibrium is also possible. In a pooling equilibrium, both high and low quality firms
issue debt of the same maturity. Flannery argues that firms with large potential information
asymmetries (such as high-growth firms) are likely to issue short-term debt for the reason that of the
larger information costs associated with long-term debt. Firms with smaller potential information
asymmetries will be less concerned about the signaling effects of their debt maturity choice, and are
more likely to issue long-term debt.


 á
As in other signaling models, Diamond (1991, 1993) assumes that firms with favorable private
information about future profitability will prefer to issue short-term debt. Diamond argues,
nevertheless, that short-term borrowing also exposes firms to the risk of excessive liquidations. Lenders
are reluctant to refinance the debt if bad news arrives. In Diamond͛s analysis, firms with the highest
credit ratings issue short-term debt for the reason that this refinancing risk is small. Firms with lower
credit ratings prefer long-term debt to reduce this refinancing risk. Firms with very poor credit ratings,
nevertheless, are unable to borrow long-term for the reason that of the extreme adverse-selection
costs. Thus, there are two types of short-term borrowers: those with very good credit ratings and those
with very poor credit ratings; firms in between are more likely to issue long-term debt.
Rajan (1992) argues that owners of firms with public debt outstanding will continue some projects that
would be abandoned without the debt. He assumes that an optimal liquidation policy would be based
on private information. Public debt contracts, therefore, cannot be contingent on such an optimal
policy. If private lenders have access to better information about the value of the firm͛s assets,
nevertheless, sh0rtͶterm private debt contracts can induce more efficient liquidation policies.
  # 



 


rrick and Ravid (1985) analyze tax implications of the debt maturity choice. For the reason that the firm
can default on its promised debt payments, the expected value of the firm͛s tax liabilities depends on
the maturity structure of its debt whenever the term structure of interest rates is not flat. They assume
that the probability of default increases with time, and the value of the firm͛s interest tax shield is
reduced upon default. (This occurs, for example, if in reorganization, the firm faces binding constraints
on the use of tax-loss carry-backs.) If the yield curve is upward sloping, the expectations hypothesis
implies that in early years the interest expense from issuing long-term debt is greater than the expected
interest expense from rolling short-term debt. rut the interest expense is less in later years. In this case,
rrick and Ravid argue that issuing long-term debt reduces the firm͛s expected tax liability and
consequently increases the firm͛s current market value. Conversely, if the term structure is downward
sloping, issuing short-term debt increases firm value. Thus, the tax hypothesis implies that firms employ
more longͶterm debt when the term structure has a positive slope. Lewis (1990) argues that taxes have
no effect on optimal debt maturity. He notes that rrick and Ravid assume that the firm selects its
leverage before the debt-maturity structure is chosen. If optimal leverage and debt-maturity structures
are chosen simultaneously, then the debt-maturity structure is irrelevant.

For our empirical investigation of the determinants of corporate debt maturity, we construct a large
sample of firms. Our data set merges the COMPUSTAT expanded annual industrial and full-coverage
files, the COMPUSTAT research annual industrial file, and the Center for Research in Securities Prices
(CRSP) New York Stock Exchange (NYSE) / American Stock Exchange (AMEX) and NASDAQ files. We
restrict our sample to firms with Standard Industrial Classification (SIC) codes from 2000 to 5999 to
focus on the industrial corporate sector. Our data span the years 1974 through 1992.
i 




  
 
COMPUSTAT reports the amount of long-term debt payable in years one through five from the firm͛s
fiscal year end. To measure the maturity structure of a firm͛s debt, we examine the percentage of the
firm͛s total debt (long-term debt plus debt in current liabilities) that has a maturity of more than three
years. Several firms on the COMPUSTAT file report less than 0 percent or more than 100 percent of their
total debt maturing in more than three years. Since these observations apparently reflect data-coding
errors we discard them. The choice of three years, admittedly, is arbitrary. Our results are qualitatively
similar, nevertheless, using the percentage of debt maturing in more than one, two, four, or five years.͞

$307ã
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Percentage Mean Standard 25th Median 75th Value

of debt that Deviation Percentile Percentile Weighted
matures in Mean*
more than
One year 71.8 28.2 59.8 82.9 92.7 73.0
Two years 60.9 29.1 42.6 69.5 84.0 65.7
Three years 51.7 28.9 29.5 57.1 75.1 58.7
Four years 43.7 28.1 19.7 46.0 66.4 52.2
Five years 36.6 27.2 11.5 35.8 58.1 45.9
*Weighted by total debt outstanding
We measure debt maturity as the ratio of long-term debt to total debt in order to separate the debt
maturity decision from the leverage decision. Titman and Wessels (1988) examine the ratio of long-term
debt to total assets and the ratio of short-term debt to total assets. Their evidence shows that firms with
higher leverage issue both more longͶterm debt and more short-term debt. Their specification,
nevertheless, does not provide a clear picture of how the mix of long-term and short-term debt varies
with firm characteristics. ry examining long-term debt as a fraction of total debt, we more carefully
focus on the debt maturity decision.



 
    
  
 

Table 4.7 provides debt-maturity summary statistics for the pooled time series and cross-section of firms
on CRSP and COMPUSTAT between 1974 and 1992 (39,949 firm-year observations). The table reports
the percentage of total debt that matures in more than one through five years from the firm͛s fiscal
year-end. On average, these firms have 71.8 percent of their debt due in more than one year, 51.7
percent of their debt due in more than three years, and 36.6 percent of their debt due in more than five
years. There is also substantial cross-sectional variation in debt maturity. For instance, the interquartile
range for the percentage of debt due in more than three years rises from 29.5 to 75.1 percent.

To reflect the potential affect of firm size on the debt-maturity decision, we also report the value-
weighted average debt maturity. ry weighting annotations by the firm͛s total debt outstanding, this
average provides a more representative approximation of economy-wide debt maturity. On the short
end of the maturity spectrum, the value-weighted and equally Weighted averages are similar. For longer
debt maturities, nevertheless, the difference is larger. The average percentage of debt that matures in
more than five years increases from 36.6 percent (equally weighted) to 45.9 percent (value-weighted).


 



 


Using COMPUSTAT balance-sheet data gives a broad outlook of corporate debt. In addition to bonds and
mortgages, long-term debt also includes capitalize lease obligations, forestry and paper companies͛
timber contracts, publishing companies͛ royalty contracts payable, and similar long-term fixed claims.
Short-term debt (debt in current liabilities) comprises short-term notes, bank acceptances and
overdrafts, the current segment of long-term debt, and sinking funds or installments on loans.

In principle, a theory of debt maturity should be appropriate to this broad spectrum of corporate
liabilities. In practice, together with these non-debt fixed claims is unlikely to have a material effect on
the analysis. In our illustration, the most widely used non-debt fixed claims are capitalized leases.
Capitalized leases appear on the balance sheet in 44 percent of our firm-year observations. For these
firms, the lease obligations represent 20 percent of total debt, for all firm-years in the sample, lease
obligations represent 9 percent of total debt.

To the extent that the firm͛s debt comprises imbedded options in the call or sinking-fund provisions, our
measure overstates the effective maturity. This measurement-error problem introduces a potential bias
if the use of these provisions is correlated with our independent variables. For instance, firms with more
growth options might comprise more imbedded options in their debt contracts. This entails that the
firms that are anticipated to employ the shortest-term debt will have the largest overstatement.
Consequently, such a measurement problem would bias our tests against finding results regular with the
contracting-cost hypothesis.

An analogous measurement quandary occurs with affirmative covenants in debt agreements.

Affirmative covenants necessitate firms to keep up specified levels in accounting-based financial ratios.
(For instance, an affirmative covenant might specify a minimum level of working capital or net worth.)
The violation of an affirmative covenant is an event of default typically giving the lender the right to
speed up the maturity of the debt. Consequently to the extent that the debt includes affirmative
covenants, our measure also overstates effective maturities. Affirmative compacts are practically
completely employed in private debt agreements. This implies that small, risky firms, which we expect
to employ confidential debt agreements, have the biggest overstatement. This again biases our tests
against finding results consistent with the contracting-cost hypothesis.



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O
 
 R
 


Smith and Watts (1992) and Gaver and Gaver (1993) study the relationship between measures of the
firm͛s investment opportunity set and the firm͛s financing, compensation, and dividend policies. These
studies make use of the ratio of the market value of the firm͛s assets to their book value as a proxy for
growth options. The firm͛s balance sheet does not include intangible assets like growth options. More
growth options thus increase the firm͛s market value in relation to its book value. Regular with
incentive-contracting hypotheses, Smith and Watts find that the market-to-book ratio is considerably
connected with the firm͛s observed policy choices. As a result, the principal variable used in this study to
proxy for the firm͛s investment opportunity set is the market-to-book ratio. We approximate the market
value of the firm͛s assets as the book value of assets minus the book value of equity plus the market
value of equity. The marketͶto-book ratio is the predictable market value of assets divided by the book
value of assets. This estimated market-to-book ratio has several extreme observations. For instance, 98
percent of the ratios are between 0.5 and 6.9. The range for this variable, nevertheless, is 0.1 to 291.3.
To get rid of the influence of these extreme observations on the regression results, we discard
observations if the market-to-book ratio is greater than ten. (Discarding these observations reduces the
statistical meaning of this variable in the regressions, but increases the size of the coefficient.)

á
  

To estimate the effects of regulation, we construct a dummy variable that is set equal to one for firms in
regulated industries and zero otherwise. Regulated industries include railroads (SIC code 4011) through
1980, trucking (4210 and 4213) through 1980, airlines (4512) through 1978, telecommunications (4812
and 4813) through 1982, and gas and electric utilities (4900 to 4939).

)

We measure firm size as the natural logarithm of our estimate of the market value of the firm in
constant 1972 dollars.

* 
The signaling literature has given little attention to defining quality in a way that is empirically
observable. Nevertheless, signaling models all assume that managers have better (or more timely)
information about firm value than investors. To estimate quality empirically, We use the firm͛s abnormal
future earnings. We assume that high-quality (undervalued) firms have positive future abnormal
earnings and low-quality (over-valued) firms have negative future abnormal earnings. Assuming that
earnings follow a random walk, We define abnormal earnings in year t + 1 as earnings per share in year t
+ 1 (excluding extraordinary items and discontinued operations and adjusted for any changes in shares
outstanding) minus earnings per share in year t, divided by the year t share price. This variable also has
several extreme observations. For example, 98 percent of the abnormal earnings are between Ͷ 1.2
and 1.6, while the range for this variable is 92,77 3 to 1,451. We discard observations if the absolute
value of the abnormal earnings variable is greater than five. Discarding these observations has a
material effect on the estimated coefficient for the abnormal-earnings variable. This coefficient is not
significantly different from zero in any regression that includes these extreme observations. Discarding
these observations, nevertheless, has little effect on the other variables in the regression.



 


To measure the term structure of interest rates, we subtract the month-end yield on six-month
government bonds from the month-end yield on ten-year government bonds. This yield spread is then
matched with the month of the companies͛ fiscal year-end. Data on government bond yields are from
Citibase.
 

  $ 

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The debt-maturity is one of numerous financing choices that the firm must make at the same time.
When determining how to finance itself, the firm must choose between debt and equity. If it chooses
debt, it must also choose the maturity of that debt, the priority, whether the debt is public or private,
and other contract provisions, together with call and convertibility provisions and restrictive covenants.
In an ideal world, we would like to provide a system of instantaneous equations to control for these
joint decisions. Unluckily, the theory currently is not rich enough to provide the essential identifying
limitations for this system.
Although these financing decisions are decided jointly, theory suggests that they are driven by the same
underlying firm characteristics. For case in point, a firm with more growth options in its investment
opportunity set is likely to have less debt its capital structure, and the debt it issues is likely to have
shorter average maturity. A growth firm is also more likely to issue private debt with higher priority and
more restrictive covenants. Our regressions should be interpreted as reduced-form regressions from this
system. Since we are unable to provide the identifying restrictions for the simultaneous system, we
restrict our choice of independent variables to those that we believe are most likely to be exogenousͶ
i.e., measures of the firm͛s investment opportunity set, its informational environment, and its regulatory
and tax status.
Table 4.8 reports pooled time series, cross-sectional regressions of the percentage of a firm͛s debt
payable in more than three years on its market-to-book ratio, a regulation dummy, the log of firm value,
the firm͛s future abnormal earnings, and the risk-free term structure. Regression (1) in table 4.8 is a
ordinary-least-squares (OLS) regression on the entire pooled time series and cross section (37,979 firm-
year observations.)3
Since the normal OLS assumption of independent errors is unlikely to be satisfied in this regression, t-
statistics are potentially overstated. To account for the potential error-dependence problem, regression
(2) is a cross-account for the potential using the time-series mean of each variable by firm (5,545
observations). Running the regression in a single cross-section eliminates the problem of serially
correlated errors. The cross-sectional regression preserves the dispersion across firms, but does not
exploit any time-series variation in the observations.
In regression (3), we use a fixed-effects regression as an alternate method for dealing with the problem
of serially correlated errors. In this regression, we subtract the firm-specific time-series mean for each
variable from each observation. (This technique is equivalent to adding a dummy variable for each firm
in the sample.) Thus, although this regression preserves the time-series dispersion in the sample, it
ignores most of the information from differences across firms.




 
 
    



  








  

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$30F: Regressions Estimating the Determinants of Corporate Debt Maturity
(1) (2) (3)
Independent Variable Predicted Pooled Cross-Sectional Fixed Effects
sign Regression Regression
Intercept 36.74 31.49 N.A.
(89.50) (27.98)
Market-to-book ratio ʹ ʹ4.37 ʹ4.78 ʹ2.33
(ʹ25.42) (ʹ15.12) (ʹ9.51)
Regulation dummy + 6.66 8.91 3.54
(8.96) (3.97) (3.29)
Log of firm value + 5.28 6.31 5.03
(75.98) (35.98) (18.81)

3
The number of observations in Table 4.8 is smaller than the number of observations in Table 4.7 for the reason
that the abnormal earnings variable cannot be calculated for the final data year, and for the reason that
observations with extreme values are excluded from the regressions. Less than 1 percent of the sample (386 firm-
years) is discarded due to extreme observations.
Abnormal earnings ʹ ʹ1.94 ʹ2.94 Ͷ
(ʹ5.04) (ʹ2.38)
Term Structure + ʹ0.32 ʹ0.63 ʹ0.21
(ʹ3.07) (ʹ1.21) (ʹ2.84)
R2 0.16 0.26 0.61a
F 1414.42 398.14 116.17
Number of observations 37969 5545 116.17

a
The adjusted R2 for the fixed effects regression includes the fixed effects. The adjusted R2 excluding the
fixed effects is 0.02.
b
. The fixed effects regression excludes firms with only one observation.



   
Consistent with the contracting-cost hypothesis, the coefficient on the market-to-book ratio is negative
and highly significant in all three regressions. The t-statistic for this variable ranges from ʹ9.51 for the
fixed-effects regression to ~25/12 for the pooled OLS regression. This coefficient indicates that, on
average, firms with more growth options (as proxied by the market-to-book ratio) have significantly less
long-term debt. It is also consistent with the hypothesis that firms with larger potential information
asymmetries issue long-term debt.
To derive a better understanding of the economic significance of this result, we calculate the impact of
moving from the tenth to the ninetieth percentile for the market-to-book ratio in our sample. The
estimated coefficient from the pooled regression implies that this move reduces the fraction of long-
term debt by 9.6 percentage points.
The dummy variable for firms in regulated industries is significantly positive; t-statistics range from 3.29
to 8.96. Other things equal, regulation increases the proportion of long-term debt by 6.6 percentage
points.
The coefficient for the log of firm value is positive and significant in all three regressions; t-statistics
range from 18.81 to 75.98. The economic significance of this variable is also dramatic. The pooled-
regression coefficient implies that moving from the tenth to the ninetieth percentile for firm size
increases the fraction of long-term debt by 27.7 percentage points.
The regression provide some support for the signaling hypothesis; t-statistics range from ʹ2.38 to ʹ5.04,
implying that firms with higher future earnings have more short-term debt. rut the economic
significance of this factor is questionable. For abnormal earnings, the pooled regression coefficient
implies that moving from the tenth to the ninetieth percentile reduces the fraction of long-term debt by
0.6 percentage points. While the time-series stability of a firm͛s investment opportunities is plausible,
firm quality is less likely to be stable over time. For example, such stability would be difficult to reconcile
with the existing evidence on market efficiency. The prediction of the signaling hypothesis is thus
primarily time-series in nature. Consequently, it is not surprising that the coefficient on the abnormal-
earnings variable has lower significance in the cross-sectional regression.
Table 4.8 results provide no support for the rrick and Ravid tax hypothesis. Inconsistent with their
hypothesis, the coefficient for the term-structure variable is significantly negative in the pooled and
fixed-effects regressions. For the term-structure variable, the point estimate from the pooled regression
implies that moving from the tenth to the ninetieth percentile of the term-structure variable would
increase long-term debt by only 1.1 percentage points. This limited impact is broadly consistent with
Lewis͛ (1990) analysis; he argues that if optimal debt-asset ratios and debt-maturity structures are
chosen simultaneously, then taxes do not affect optimal debt maturity. The prediction of the tax
hypothesis is also primarily time-series in nature.
The F-statistics indicate that each of the regressions in Table 4.8 is significant at reasonable levels.
Adjusted R2s of 0.16 and 0.26 in the pooled and cross-sectional regressions with the much smaller R2 of
0.02 in the fixed-effects regression (when the influence of the fixed effects are excluded) suggest that it
is primarily the variation in maturity structure across firms that provides the explanatory power in these
regressions.
 
  
h 

 "  

Smith and Watts (1992) argue that if the firm͛s investment opportunity set is an important determinant
of its financing, dividend, and compensation policies, then the investment opportunity set induces
correlations among these corporate policies. If the firm͛s investment opportunity set is also an
important determinant of its debt maturity structure, then debt maturity should be correlated with
leverage, payout, and compensation policies.
In table 4.9, we report the Pearson correlation coefficients between the percentage of debt payable in
more than three years, leverage (book value of debt dividend by the market value of the firm), and
dividend yield (dividend per share divided by price.) As predicted by the incentive-contracting
hypothesis, the correlation between debt maturity and leverage is significantly positive, indicating that
firms with greater leverage have more long-term debt. The correlation between debt-maturity and
dividend yield is also significantly positive, indicating that firms with higher dividend yields tend to have
more long-term debt.
h

302*
 


 

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 ;

Sample: All firms on both Center for Research in Securities Prices and COMPUSTAT between 1974 and
1992 with Standard Industrial Classification (SIC) codes from 2000 to 5999. 39,949 observations. ( -
values in parentheses.)
Percentage of Debt Due Leverage Dividend Yield
in More than 3 years
Percentage of debt due 1.000
in more than 3 years
Leverage 0.120 1.000
(0.0001)
Dividend yield 0.049 0.040
(0.0001) (0.0001)

ã


   

  R 
 ã
The market-to-book ratio is an admittedly noisy proxy for growth options. To analyze the robustness of
our results to alternate proxies, we reestimate the regressions reported in table 4.9. In table 4.10, we
examine the firms͛ annual research and development expenses as a percentage of firm value,
depreciation as a percentage of firm value, the earnings-price ratio, and the asset-return standard
deviation (the firm͛s stock-return standard deviation in percent times its equity-to-value ratio). We
expect firms with lower research and development expenses, more depreciation expenses, higher
earnings-price ratios and lower return standard deviations, to have more tangible assets and fewer
growth options in their investment opportunity sets. In these regressions, the coefficients on the
investment-opportunity set proxies are all statistically significant ( -statistics range from 12.06 to 28.75
in absolute value) and have the signs predicted by the contracting cost hypothesis. (The sample sizes for
these regressions are smaller than the sample size in table 4.8 due to missing COMPUSTAT data.)
$ 305 ã


     
 

  " 

   

    

 $



The percentage of debt that matures in more than three years is regressed on a proxy for the firm͛s
investment opportunity set, a dummy variable for firms in regulated industries, the natural log of firm
value (market value of equity plus book value of liabilities in constant amount of money), the firm͛s
future abnormal earnings, and the risk-free term structure (the difference between ten-year
government bond yields and six-month government bond yields). The investment-opportunity-set
variables include the firm͛s research and development (R&D) expense divided by firm value,
depreciation expense divided by firm value, the earnings-price ratio, and the firm͛s asset return
standard deviation (stock return standard deviation times the equity-to-firm-value ratio).
Sample: All firms on both Center for Research in Securities Prices and COMPUSTAT between 1974 and
1991 with Standard Industrial Classification (SIC) codes from 2000 to 5999. (White-adjusted -statistics in
parentheses)
Independent Variable Predicte (1) (2) (3) (4)
d Sign
Intercept 35.83 28.30 31.72 44.87
(71.77) (66.25) (89.98) (79.92)
R&D/firm value ʹ ʹ0.77
(ʹ15.05)
Depreciation/firm value + 0.74
(12.06)
Earnings-price ratio + 13.21
(20.59)
Asset return std. ʹ 4.50 6.17 7.37 6.32
deviation (2.87) (8.10) (9.95) (8.72)
Log of firm value + 4.37 5.31 4.96 4.05
(49.20) (75.46) (69.33) (50.39)
Abnormal earnings ʹ ʹ1.78 ʹ2.39 2.30 ʹ1.60
(ʹ3.33) (ʹ6.16) (4.57) (ʹ4.06)
Term structure + ʹ0.77 ʹ0.59 ʹ0.37 ʹ0.25
(ʹ5.58) (ʹ5.78) (ʹ3.55) (ʹ2.42)
2
R 0.12 0.14 0.15 0.16
F 627.80 126.15 1296.79 1347.16
Number of 22072 37955 37643 35274
observations

Including these alternate measures of the investment opportunity set generally leaves unaffected the
other estimated coefficients. A noteworthy exception is in regression (3). If the earnings-price ratio is
used as the measure of growth options, the abnormal-earnings variable changes sign and becomes
significantly positive (the -statistics is 4.57). This suggests potential regression misspecification and
multicollinearity between the variables. In an efficient market, firms with high expected growth rates in
earnings will have high current prices; thus, on average, firms with large abnormal future earnings tend
to have low current earnings-price ratios.
ã

  

 i  
 


  

Firms with little outstanding debt are likely to receive short-term loans from a bank rather than issue
long-term bonds and incur the higher fixed costs of a public issue. Thus, there is a potential mechanical
association between leverage and debt maturity involving firms with low levels of debt. Smith and Watts
(1992) find a negative relation between leverage and the firm͛s market-to-book ratio. Hence, a
mechanical association between leverage and debt maturity could generate a spurious relation between
debt maturity and the firm͛s market-to-book ratio.
To test for this potential spurious correlation, we exclude firms that have small amounts of total debt.
Regression (1) in Table 4.11 reports the coefficients from our basic regression excluding firms that have
less than TZS50 million of total debt. (The TZS50 million cutoff is approximately equal to the tenth
percentile of our sample firms that have public debt ratings.) Excluding these firms reduces the number
of observations from 37,969 to 11,798 and the number of different firms from 5,545 to 1,580.
The -statistics for the estimated coefficients generally decline with the sample size. Nevertheless the
coefficient on the market-to-book ratio remains negative and significant, and the coefficient on the
regulation dummy remains positive and significant as in all previous regressions. Thus, a mechanical
relation debt maturity and the total amount of debt or leverage does not appear to drive our basic
results.
The only material change in this regression is that the coefficient on firm size is small and only
marginally significant. If we exclude firms with less that TZS100 million of total debt (approximately
equal to the twenty-fifth percentile of firms with public debt ratings in our sample), the coefficients for
the market-to-book ratio and the regulation dummy are again unaffected. Nevertheless, the coefficient
on firm size now becomes negative and statistically significant. This effect on the firm-size coefficient
indicates a nonmonotonic relation between firm size and debt maturity. Debt maturity increases with
firm size for firms smaller than TZS1 billion of market value. After that point, there appears to be a
negative relation size and maturity.

  




As noted above, scale economies associated with public debt issues make this market inaccessible to
many companies with small amounts of total debt.
$ 30 ã


     
 

  " 

   

    

 $



The percentage of debt that matures in more than three years is regressed on the firm͛s market-to-book
ratio, a dummy variable for firms in regulated industries, the natural log of firm value (market value of
equity plus book value of liabilities in constant amount of money), the firm͛s future abnormal earnings,
the risk-free term structure (the difference between ten-year government bond yields and six-month
government bond yields), dummy variables for firms with Standard and Poors bond and commercial-
paper ratings, a numeric variable for the firm͛s bond rating (set equal to one for AAA through 27 for CCC
or below, and equal to 28 for nonrated firms), and three-digit SIC industry dummy variables.
Sample: All firms on both Center for Research in Securities Prices and COMPUSTAT between 1974 and
1991 with Standard Industrial Classification (SIC) codes from 2000 to 5999. (White-adjusted -statistics
are in parentheses)
    h

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    *$
r    6A


9

$ 
   
  

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Dã15 *

  
 


  (4)(6) (3)
$
()
Intercept 64.98 37.38 ʹ2.76 NAa
(60.67) (87.40) (ʹ1.23)
Market-to-book ʹ2.53 ʹ4.12 ʹ4.05 ʹ3.58
ratio (ʹ4.63) (ʹ24.12) (ʹ23.84) (ʹ19.84)
Regulation dummy 7.48 6.86 6.70 5.09
(10.04) (8.93) (8.69) (4.55)
Log of firm value 0.39 4.72 5.00 4.99
(2.51) (55.69) (57.67) (62.44)
 Abnormal earnings ʹ1.26 ʹ1.95 ʹ1.94 ʹ1.72
(ʹ1.57) (ʹ5.06) (ʹ4.94) (ʹ4.54)
Term structure 0.04 ʹ0.30 ʹ0.39 ʹ0.30
(ʹ2.90) (ʹ3.83) (ʹ2.98)
rond rating dummy 11.21 33.69
(28.22) (25.97)
Commercial paper ʹ13.72 ʹ9.52
dummy (ʹ20.67) (ʹ14.20)
rond rating for 1.40
rated firms (18.44)
F-statistic for [25.82]
industry dummiesb
R2 0.01 0.17 0.18 0.21
F 21.03 1138.51 1043.92 932.49
Number of 11798 37969 37969 37969
observations

a
This regression is rum without an intercept for the reason that there is a dummy variable for each 3-
digit SIC industry.
b
The F-statistic for the industry dummies (in parentheses) tests whether the industry dummies are
jointly different from zero.

Since public debt is issues tend to have long maturities, this implies a potential mechanical relation
between access to the public debt market and a firm͛s debt maturity.
Similarly, the high fixed cost of commercial paper programs excludes all but the largest firms from this
source of funds. Commercial paper (short-term promissory notes issued in the open market) offers an
alternative to bank borrowing for large corporations with strong credit ratings. The most common
maturity of commercial paper is 30 to 50 days. (The maturity of commercial paper is generally less than
270 days for the reason that the Securities Act of 1933 exempts such issues from registration.) Thus,
firms with commercial paper programs are likely to have more short-term debt.
We examine the sensitivity of our results to the firms͛ use of public debt and commercial paper. In
regression (2) of table 4.11 we include dummy variables to indicate whether the firm has an Standard
and Poor͛s (S&P) bond rating or an S&P commercial paper rating. As expected, the coefficient for the
bond-rating dummy is significantly positive and the coefficient for the commercial-paper dummy is
significantly negative. Nevertheless, the inclusion of these variables does not affect the size or the
statistical significance of the other coefficient. Thus, access to public debt and commercial paper
markets does not appear to be driving our basic results.


 á
We have used the bond and commercial paper ratings to provide information about potential
mechanical relations between the firm͛s choice of debt instruments and debt maturity; these results are
also potentially relevant for examining signaling models that relate credit risk to debt maturity. Although
the data are not ideally suited to test these hypotheses, we examine the relation between bond ratings
and debt maturity. Regression (3) in table 4.11 includes a bond-rating variable; it equals to one if the
firm͛s S&P bond rating is AAA, through 27 if the bond rating is CCC or below. This variable is set equal to
28 for firms without S&P bond ratings. The coefficient on the bond-rating variable is positive and
significant ( -statistic is 18.44), indicating that lower-rated firms issue more long-term debt than higher-
rated firms. The positive coefficient for the bond-rating dummy variable, nevertheless, indicates that
non-rated firms (which tend to be small firms with the lowest credit standing) have more short-term
debt. Thus, the evidence suggests a nonmonotonic relation between credit standing and debt maturity
as predicted by Diamond (1993).
Although there is evidence of a nonmonotonic relation between debt maturity and credit standing, this
evidence should be interpreted with some caution. For firms with public debt ratings, the relation
between debt maturity and bond rating is strictly monotonic; the nonmonotonicity is driven solely by
the nonrated firms. As one moves from the sample of firms with S&P bond ratings to those that do not
have ratings, nevertheless, many things change. In particular, firms typically get bond ratings only if they
issue public debt. Thus, firms without S&P bond ratings have mostly private debt which, on average, has
shorter maturity regardless of the firm͛s credit rating.


 i


    
O


 
To determine the relative importance of industry-specific versus firm-specific effects, we reestimate the
regressions in Table 4.8 including dummy variables for 2-digit and 3-digit SIC industries. We report the
results using 3-digit industry dummies in regression (4) of Table 4.11. The F-statistic for the industry
dummies indicates that they are jointly different from zero (FM25.82). Nevertheless, the adjusted R2 in
this regression increases from 0.16 in regression (1) of Table 4.8 to only 0.21 with the 3-digit industry
dummies. The adjusted R2 for the regression with 2-digit industry dummies (not reported here) is 0.19.
In addition, adding these dummy variables has no material effect on any of the other regression
coefficients. Evidence of standard industry practices still would be consistent with the hypothesis in
section I of this topic. For example, knowledge of a firm͛s industry may be highly correlated with its
investment opportunities. Nevertheless, the evidence suggests that firm-specific characteristics (such as
size and market-to-book ratios) are more important than industry-specific effects in determining a firm͛s
debt maturity.



  
The four major industries in our sample (airlines, railroads, trucking, and telecommunications)
experienced significant deregulation during our sample period. If the effect of regulation is to decrease
managerial discretion over future investment decisions, and thus increase debt maturity, then these
firms should shorten their debt maturity following deregulation. As predicted, all four industries have
significantly more short-term debt after deregulation. Following deregulation, the average percentage
of debt due in more than three years fell from 67 to 64 percent in the airline industry, from 76 to 67
percent in the railroad industry, from 57 to 46 percent in the trucking industry, can be explained almost
entirely by the more general trend in debt maturities. Including this more general time trend in debt
maturity eliminates the significance of the effect of deregulation.




The fact that the effects of deregulation are covered by the general time trend in debt maturity raises
the likelihood that this trend has a significant effect on other regression coefficients. We test the
importance of this time trend and for other temporal effects (such as business cycle effects). We
reestimate the regressions in Table 4.8 using both a linear time-trend variable and annual dummy
variables. As expected both the time-trend and dummy-variable approaches indicate that economy-
wide debt maturity declined over this period. None of the other regression coefficients are substantially
affected in magnitude or statistical significance, nevertheless, by the inclusion of a time trend or year
dummies. (Since there is no material change in any of the regression coefficients of interest, we do not
report this regression.)
Our examination of the determinants of corporate debt maturity supports the hypothesis that firms
with more growth options in their investment opportunity sets issue more short-term debt. This result is
consistent with Myers͛ (1977) prediction that reducing debt maturity helps control the underinvestment
problem. We also find that regulated firms issue more long-term debt. This is consistent with Smith͛s
(1986) argument that regulation reduces the firm͛s discretion over corporate investment policy, thus
controlling the underinvestment problem. The empirical results are robust to alternate measures of the
investment opportunity set. Our methods also suggest that growth options in the firm͛s investment
opportunity set are important in explaining both the time-series and cross sectional variation in the
firm͛s maturity structure.
We provide evidence of a strong association between firm size and debt maturity: large firms issue a
significantly higher proportion of long-term debt. This is consistent with the observation that small firms
rely more heavily on bank debt that typically has shorter maturity than public debt. We also document a
reliably positive association between the existence of an S&P bond rating and debt maturity, and a
reliably negative association between the existence of a commercial paper rating and debt maturity.
Our evidence provides less support for the hypothesis that firms use the maturity of their debt to signal
information to the market. Although the estimated coefficient on the abnormal earnings variable is
significantly negative, the economic impact of this variable is trivial. The results are consistent,
nevertheless, with the hypothesis that firms with potentially large information asymmetries (such as
high-growth firms) issue more short-term debt. Consistent with Diamond͛s (1993) hypothesis, our
evidence also suggests that firms with the highest and lowest credit risk issue short-term debt while
firms with intermediate credit risk issue long-term debt. The tax hypothesis is not important in
explaining the debt maturity choice.
Our analysis has some potentially significant limitations. First, the power of the hypothesis tests are not
all equal. For instance, we examine variation in debt maturity across all of the firms͛ outstanding debt.
More powerful tests of the signaling hypotheses may come from examining the variation in debt
maturity at issuance.
Second our data employ a broad definition of debt. Although we believe the behavior of the aggregate is
more significant than the behaviour of any single component, more disaggregated data would facilitate
examination of the richness of the debt-maturity policy. For example, our evidence indicates that firms
with more growth options in their investment opportunity sets issue more short-term debt. Yet we do
not know how much of the total variation is (such as long-term public debt and short-term bank debt)
and how much is due to variation in the maturity of a given set of instruments (such as 20 year and 12
year public debentures). Similarly, we do not have data on foreign borrowing. Thus, we cannot identify
the variation in debt maturity attributable to the differential maturity of Tanzania versus foreign debt. A
more detailed examination of the mix of debt instruments issued by different types of firms would
provide important texture to our understanding of how firms achieve their observed debt maturity
structure.
To end with, we have simply taken the COMPUSTAT definition of the amount of debt that matures in
given year to analyze the maturity choice. Many debt issues have provisions that specify imbedded
options to modify the repayment schedule. For instance, both call provisions and optional sinking fund
payments reduce the effective maturity of a debt issue. Debt covenants, particularly affirmative
covenants in private debt agreements, also allow the lender to accelerate the payment schedule if the
borrower breaches the covenant. The appropriate adjustment in our methods to reflect this maturity
flexibility is not obvious.
*ããr ""¢ããh¢G* ¢
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What is the optimal mix of debt and equity for a firm? In the previous discussion we looked at the
qualitative trade-off between debt and equity, but we did not develop the tools we need to analyze
whether debt should be 0 percent, 20 percent, 40 percent, or 60 percent of capital. Debt is always
cheaper than equity, but using debt increases risk in terms of default risk to lenders and higher earnings
volatility for equity investors. Thus, using more debt can increase value for some firms and decrease
value for others, and for the same firm, debt can be beneficial up to a point and destroy value beyond
that point. We have to consider ways of going beyond the generalities in the last chapter to specific
ways of identifying the right mix of debt and equity.
In the following discussion we explore four ways to find an optimal mix. The first approach begins with a
distribution of future operating income; we can then decide how much debt to carry by defining the
maximum possibility of default we are willing to bear. The second approach is to choose the debt ratio
that minimizes the cost of capital. We review the role of cost of capital in valuation and discuss its
relationship to the optimal debt ratio. The third approach, like the second, also attempts to maximize
firm value, but it does so by adding the value of the unlevered firm to the present value of tax benefits
and then netting out the expected bankruptcy costs. The final approach is to base the financing mix on
the way comparable firms finance their operations.


 ¢
 
The operating income approach is the simplest and one of the most intuitive ways of determining how
much a firm can afford to borrow. We determine a firm͛s maximum acceptable probability of default as
our starting point, and based on the distribution of operating income and cash flows, we then estimate
how much debt the firm can carry.
ã  ¢

R 
   ¢ 
We begin with an analysis of a firm͛s operating income and cash flows, and we consider how much debt
it can afford to carry based on its cash flows. The steps in the operating income approach are as follows:
1. We assess the firm͛s capacity to generate operating income based on both current conditions
and past history. The result is a distribution for expected operating income, with probabilities
attached to different levels of income.
2. For any given level of debt, we estimate the interest and principal payments that have to be
made over time.
3. Given the probability distribution of operating income and the debt payments, we estimate the
probability that the firm will be unable to make those payments.
4. We set a limit or constraint on the probability of its being unable to meet debt payments.
Clearly, the more conservative the management of the firm, the tighter this probability
constraint will be.
5. We compare the estimated probability of default at a given level of debt to the probability
constraint. If the probability of default is higher than the constraint, the firm chooses a lower
level of debt; if it is lower than the constraint, the firm chooses a higher level of debt.
'     R 
   ¢ 
Although this approach may be intuitive and simple, it has key drawbacks. First, estimating a distribution
for operating income is not as easy as it sounds, especially for firms in businesses that are changing and
volatile. The operating income of firms can vary widely from year to year, depending on the success or
failure of individual products. Second, even when we can estimate a distribution, the distribution may
not fit the parameters of a normal distribution, and the annual changes in operating income may not
reflect the risk of consecutive bad years. This can be remedied by calculating the statistics based on
multiple years of data. This approach is also an extremely conservative way of setting debt policy for the
reason that it assumes that debt payments have to be made out of a firm͛s operating income and that
the firm has no access to financial markets or pre-existing cash balance. Finally, the probability
constraint set by management is subjective and may reflect management concerns more than
stockholder interests. For instance, management may decide that it wants no chance of default and
refuse to borrow money as consequence.
    R 
   ¢ 
The operating income approach described in this section is simplistic for the reason that it is based on
historical data and the assumption that operating income changes are normally distributed. We can
make it more sophisticated and robust my making relatively small changes.
 ! We can look at simulations of different possible outcomes for operating income, rather than
looking at historical data; the distributions of the outcomes can be based both on past data and
on expectations for the future.
! Instead of evaluating just the risk of defaulting on debt, we can consider the indirect bankruptcy
costs that can accrue to a firm if operating income drops below a specified level.
! We can compute the present value of the tax benefits from the interest payments on the debt,
across simulation, and thus compare the expected cost of bankruptcy to the expected tax
benefits from borrowing.
With these changes, we can look at different financing mixes for a firm and estimate the optimal
debt ratio as that mix that maximizes the firm͛s value.

 
¢
 
In the beginning of this unit we estimated the minimum acceptable hurdle rates for equity investors (the
cost of equity), and for all investors in the firm (the cost of capital). We defined the cost of capital to be
the weighted average of the costs of the different components of financingʹincluding debt, equity and
hybrid securitiesʹused by a firm to fund its investments. ry altering the weights of the different
components, firms might be able to change their cost of capital. In the cost of capital approach, we
estimate the costs of debt and equity at different debt ratios, use these costs to compute the costs of
capital, and look for the mix of debt and equity that yields the lowest cost of capital for the firm. At this
cost of capital, we will argue that firm value is maximized.
    

h "


In the previous unit we laid the foundations for estimating the cost of capital for a firm. We argued that
the cost of equity should reflect the risk as perceived by the marginal investors in the firm. If those
marginal investors are diversified, the only risk that should be priced in should be the risk that cannot be
diversified away, captured in a beta (in the CAPM) or betas (in multi factor models). If the marginal
investors are not diversified, the cost of equity may reflect some or all of the firm-specific risk in the
firm.
The cost of debt is a function of the default risk of the firm and reflects the current cost of long term
borrowing to the firm. Since interest is tax deductible, we adjust the cost of debt for the tax savings,
using the marginal tax rate, to estimate an after-tax cost. In summary, the cost of capital is a weighted
average of the costs of equity and debt, with the weights based upon market values:
$
 
  
   $
     |&
  $
  $

To understand the relationship between the cost of capital and optimal capital structure, we first have
to establish the relationship between firm value and the cost of capital. In the earlier sections of this
unit we noted that the value of a project to a firm could be computed by discounting the expected cash
flows on it at a rate that reflected the riskiness of the cash flows, and that the analysis could be done
either from the viewpoint of equity investors alone or from the viewpoint of the entire firm. In the latter
approach, we discounted the cash flows to the firm on the project, that is, the project cash flows prior to
debt payments but after taxes, at the project͛s cost of capital.
Extending this principle, the value of the entire firm can be estimated by discounting the aggregate
expected cash flows to the firm over time at the firm͛s cost of capital. The firm͛s aggregate cash flows
can estimated as cash flows after operating expenses, taxes, and any capital investments needed to
create future growth in both fixed assets and working capital, but before debt payments.
Cash Flow to Firm M ErIT (1ʹt) ʹ (Capital Expenditures ʹ Depreciation) ʹ Change in Non-cash
Working Capital
The value of the firm can then be written as
  
40 0
 
' 0
  Þ
| |
6¢44
The value of a firm is therefore a function of its cash flows and its costs of capital. In the special case
where the cash flows to the firm remain constant as the debt/equity mix is changed, the value of the
firm will increase as the cost of capital decreases. If the objective in choosing the financing mix for the
firm is the maximum of firm value, this can be accomplished, in this case, by minimizing the cost of
capital. In the more general case where the cash flows to the firm themselves change as the debt ratio
changes, the optimal financing mix is the one that maximizes firm value.
  
¢
 Hr
 
To use the cost of capital approach in its simplest form, where the cash flows are fixed and only the cost
of capital changes, we need estimates of the cost of capital at every debt ratio. In making these
estimates, the one thing we cannot do is keep the costs of debt and equity fixed, while changing the
debt ratio. In addition to being unrealistic in its assessment of risk as the debt ratio changes, this analysis
will yield the unsurprising conclusion that the cost of capital is minimized at a 100 percent debt ratio.
As the debt ratio increases, each of the components in the cost of capital will change. Let us start with
the equity component. Equity investors are entitled to the residual earnings and cash flows in a firm,
after interest and principal payments have been made. As that firm borrows more money to fund a
given level of assets, debt payments will increase, and equity earnings will become more volatile. This
higher earnings volatility, in turn, will translate into a higher cost of equity. In the language of the CAPM
and multi-factor models, the beta or betas we use for equity should increase as the debt ratio goes up.
The debt holders will also see their risk increase as the firm borrows more. Holding operating income
constant, a firm that contracts to pay more to debt holders has a greater change of defaulting, which
will result in a higher cost of debt. As an added complication, the tax benefits of interest expenses can
be put at risk, if these expenses become greater than the earnings.
The key to using the cost of capital approach is coming up with realistic estimates of the cost of equity
and debt at different ratios. The optimal financing mix for a firm is trivial to compute if one is provided
with a schedule that relates to costs of equity and debt to the debt ratio of the firm. Computing the
optimal debt ratio then becomes purely mechanical. To illustrate, assume that you are given the costs of
equity and debt at different debt levels for a hypothetical firm and that the after-tax cash flow to this
firm is currently TZS200 million. Assume also that these cash flows are expected to grow at 3 percent a
year forever, and are unaffected by the debt ratio of the firm. The cost of capital schedule is provided in
Table 4.12, along with the value of the firm at each level of debt.
$304:¢h

9 $
 
>(I")   ¢
   h

9
"%
   

$
0 10.50 % 4.80 % 10.50 % TZS2,747
10 % 11.00 % 5.10 % 10.41 % TZS2,780
20 % 11.60 % 5.40 % 10.36 % TZS2,799
30 % 12.30 % 5.52 % 10.27 % TZS2,835
40 % 13.10 % 5.70 % 10.14 % TZS2,885
50 % 14.00 % 6.10 % 10.05 % TZS2,922
60 % 15.00 % 7.20 % 10.32 % TZS2,814
70 % 16.10 % 8.10 % 10.50 % TZS2,747
80 % 17.20 % 9.00 % 10.64 % TZS2,696
90 % 18.40 % 10.20 % 11.02 % TZS2,569
100 % 19.70 % 11.40 % 11.40 % TZS2,452


      
   ß
 
 !"  
 !"
The value of the firm increases (decreases) as the WACC decreases (increases), as illustrated in Figure
4.4.
h

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This illustration makes the choice of an optimal financing mix seem trivial and it obscures some real
problems that may arise in its applications. First, we typically do not have the benefit of having the
entire schedule of costs of financing, prior to an analysis.
In most cases, the only level of debt about which there is any certainty about the cost of financing is the
current level. Second, the analysis assumes implicitly that the level of cash flows to the firm is
unaffected by the financing mix of the firm and consequently by the default risk (or bond rating) for the
firm. Although this may be reasonable in some cases, it might not in others. For instance, a firm that
manufactures consumer durables (cars, televisions, etc.) might find that its sales and operating income
drop if its default risk increases for the reason that investors are reluctant to buy its products. We will
deal with the computational component of estimating costs of debt, equity and capital first in the
standard cost of capital approach and then follow up by examining how to bring in changes in expected
cash flows into the analysis in the enhanced cost of capital approach.
 ã 
 
¢
 
In the standard cost of capital approach, we keep the operating income and cash flows fixed, while
changing the cost of capital. Not surprisingly, the optimal debt ratio is the one that minimizes the cost of
capital. While the assumptions seem heroic, it is a good starting point for the discussion.
ã   

    

We need three basic inputs to compute the cost of capital ʹ the cost of equity, the after-tax cost of debt,
and the weights on debt and equity. The costs of equity and debt change as the debt ratio changes, and
the primary challenge of this approach is in estimating each of these inputs.
Let us begin with the cost of equity.
Cost of Equity M Risk-Free Rate + ɴlevered (Risk Premium)
The cost of debt for a firm is a function of the firm͛s default risk. As firms borrow more, their default risk
will increase and so will the cost of debt. If we use bond ratings as the measure of default risk, we can
estimate the cost of debt in three steps. First, we estimate a firm͛s money debt and interest expenses at
each debt ratio; as firms increase their debt ratio, both money debt and interest expenses will rise.
Second, at each debt level, we compute a financial ratio or ratios that measure default risk and use the
ratio(s) to estimate a rating for the firm; again, as firms borrow more, this rating will decline. Third, a
default spread, based on the estimated rating, is added on to the risk-free rate to arrive at the pretax
cost of debt. Applying the marginal tax rate to this pretax cost yields an after-tax cost of debt.
Once we estimate the costs of equity and debt at each debt level, we weight them based on the
proportions used of each to estimate the cost of capital. Although we have not explicitly allowed for a
preferred stock component in this process, we can have preferred stock as part of capital. Nevertheless,
we have to keep the preferred stock portion fixed while changing the weights on debt and equity. The
debt ratio at which the cost of capital is minimized is the optimal debt ratio.
In this approach, the effect of changing the capital structure, on firm value, is isolated by keeping the
operating income fixed, and varying only the cost of capital. In practical terms, this requires us to make
two assumptions. First, the debt ratio is decreased by raising new equity and retiring debt; conversely,
the debt ratio is increased by borrowing money and buying back stock. This process is called
recapitalization. Second, the pretax operating income is assumed to be unaffected by the firm͛s
financing mix and, by extension, its bond rating. If the operating income changes with a firm͛s default
risk, the basic analysis will not change, but minimizing the cost of capital may not be the optimal course
of action, for the reason that the value of the firm is determined by both the cash flows and the cost of
capital. The value of the firm will have to be computed at each debt level and the optimal debt ratio will
be that which maximizes firm value.

   
The optimal debt ratio we estimate for a firm is a function of all the inputs that go into the cost of capital
computation ʹ the beta of the firm, the risk-free rate, the risk premium, and the default spread. It is also
indirectly a function of the firm͛s operating income, for the reason that interest coverage ratios are
based on this income, and these ratios are used to compute ratings and interest rates.
The determinants of the optimal debt ratio for a firm can be divided into variables specific to the firm,
and the macroeconomic variables. Among the variables specific to the firm that affect its optimal debt
ratio are the tax rate, the firm͛s capacity to generate operating income, and its cash flows. In general,
the tax benefits from debt increases as the tax rate goes up. In relative terms, firms with higher tax rates
will have higher optimal debt ratios than will firms with lower tax rates, other things being equal. It also
follows that a firm͛s optimal debt ratio will increase as its tax rate increases. Firms that generate higher
operating income and cash flows as a percent of firm market value also can sustain much more debt as a
proportion of the market value of the firm, for the reason that debt payments can be covered much
more easily by prevailing cash flows.
The macroeconomic determinants of optimal debt ratios include the level of interest rates and default
spreads. As interest rates rise, the costs of debt and equity both increase. Nevertheless, optimal debt
ratios tend to be lower when interest rates are higher, perhaps for the reason that interest coverage
ratios drop at higher rates. The default spreads commanded by different ratings classes tend to increase
during recessions and decrease during recoveries. Keeping other things constant, as the spreads
increase, optimal debt ratios decrease for the simple reason that higher default spreads result in higher
costs of debt.
How does sensitivity analysis allow a firm to choose an optimal debt ratio? After computing the optimal
debt ratio with existing inputs, firms may put it to the test by changing both firm-specific inputs (such as
operating income) and macroeconomic inputs (such as default spreads). The debt ratio the firm chooses
as its optimal then reflects the volatility of the underlying variables and the risk aversion of the firm͛s
management.
"   
¢
 
A key limitation of the standard cost of capital approach is that it keeps operating income fixed, while
bond ratings vary. In effect, we are ignoring indirect bankruptcy costs, when computing the optimal debt
ratio. In the enhanced cost of capital approach, we bring these indirect bankruptcy costs into the
expected operating income. As the rating of the company declines, the operating income is adjusted to
reflect the loss in operating income that will occur when customers, suppliers, and investors react.
To quantify the distress costs, we have tie the operating income to a company͛s bond rating. Put
another way, we have to quantify how much we would expect the operating income to decline if a firm͛s
bond rating drops from AA to A or from A to rrr. This will clearly vary across sectors and across time.
! Across sectors, the different effects of distress on operating income will reflect how much
customers, suppliers and employees in that sector react to the perception of default risk in a
company. For example, indirect bankruptcy costs are likely to be highest for firms that produce
long-lived assets, where customers are dependent upon the firm for parts and service.
! Across time, the indirect costs of distress will vary depending how easy it is to access financial
markets and sell assets. In buoyant markets (in 1999 or 2006), the effect of a ratings downgrade
on operating income are likely to be much smaller than in a market in crisis.
While getting agreement on these broad principles is easy, we are still faced with the practical question
of how best to estimate the impact of declining ratings on operating income. We would suggest looking
at the track record of other firms in the same sector that have been down graded by ratings agencies in
the past, and the effects that the down grading has had on operating income in subsequent years.
Once we link operating income to the bond rating, we can then modify the cost of capital approach to
deliver the optimal debt ratio. Rather than look for the debt ratio that delivers the lowest cost of capital
(the decision rule in the standard approach), we look for the debt ratio that delivers the highest firm
value, through a combination of high earnings and low cost of capital.
"
  
¢
 
The cost of capital approach, which works so well for manufacturing firms that are publicly traded, can
be adapted to compute optimal debt ratios for cyclical firms, family group companies, private firms or
even for financial service firms, such as banks and insurance companies.


   h
A key input that drives the optimal structure is the current operating income. If this income is
depressed, either for the reason that the firm is a cyclical firm or for the reason that there are firm-
specific factors that are expected to be temporary, the optimal debt ratio that will emerge from the
analysis will be much lower than the firm͛s true optimal. For example, automobile manufacturing firms
will have very low debt ratios if the optimal debt ratios had been computed based on the operating
income in 2008, which was a recession year for these firm, and oil companies would have had very high
optimal debt ratios, with 2008 earnings, for the reason that high oil prices during the year inflated
earnings.
When evaluating a firm with depressed current operating income, we must first decide whether the
drop in income is temporary or permanent. If the drop is temporary, we must estimate the normalized
operating income for the firm, i.e., the income that the firm would generate in a normal year, rather
than what it made in the most recent years. Most analysts normalize earnings by taking the average
earnings over a period of time (usually five years). For the reason that this holds the scale of the firm
fixed, it may not be appropriate for firms that have changed in size over time. The right way to
normalize income will vary across firms:
 ! For cyclical firms, whose current operating income may be overstated (if the economy is
booming) or understated (if the economy is in recession), the operating income can be
estimated using the average operating margin over an entire economic cycle (usually 5 to 10
years).
Normalized Operating Income M Average Operating Margin (Cycle) * Current Sales
! For commodity firms, we can also estimate the normalized operating income by making an
assumption about the normalized price of the commodity. With an oil company, for instance,
this would translate into making a judgment about the normal oil price per barrel. This
normalized commodity price can then be used, in conjunction with production, to generate
normalized revenues and earnings.
! For firms that have had a bad year in terms of operating income due to firm-specific factors such
as the loss of a contract, the operating margin for the industry in which the firm operates can be
used to calculate the normalized operating income:
Normalized Operating Income M Average Operating Margin (Industry)*Current Sales
The normalized operating income can also be estimated using returns on capital across an economic
cycle (for cyclical firms) or an industry (for firms with firm-specific problems), but returns on capital are
much more likely to be skewed by mismeasurement of capital than operating margins.
        


When a company is part of a family group, the logic of minimizing cost of capital does not change but
the mechanics can be skewed by two factors.
! The first is that the cost of debt may be more reflective of the credit standing of the group to
which the firm belongs, rather than its own financial strength. Put another way, a distressed
company that is part of a healthy family group of companies may be able to borrow more
money at a lower rate than an otherwise similar stand-alone company. This can, at least
artificially, increase its optimal debt ratio. Conversely, a healthy company that is part of
distressed group may find its cost of debt and capital affected by perceptions about the group;
in this case, the optimal debt ratio will be lower for this company than for an independent
company.
! The second is that rather than optimizing the mix of debt and equity for individual companies,
the controllers of the family group of companies may view their objective as finding a mix of
debt and equity that maximizes the value of the group of companies. Thus, our assessments of
the capital structures of individual companies may not be particularly meaningful.
There is one final factor to consider. The consolidated operating income of the entire family group
should be more stable than the earnings of the individual companies that comprise the group, reflecting
diversification over multiple businesses. Consequently, the optimal debt computed for the family group
will be higher than the aggregate of the optimal debt for individual companies in the group.

 h
There are three major differences between public and private firms in terms of analyzing optimal debt
ratios. One is that unlike the case of publicly traded firms, we do not have a direct estimate of the
market value of a private firm. Consequently, we have to estimate firm value before we move to
subsequent stages in the analysis. The second difference relates to the cost of equity and how we arrive
at that cost. Although we use betas to estimate the cost of equity for a public firm, that usage might not
be appropriate when we are computing the optimal debt ratio for a private firm, since the owner may
not be well diversified. Finally, whereas publicly traded firms tend to think of their cost of debt in terms
of bond ratings and default spreads, private firms tend to borrow from banks. ranks assess default risk
and charge the appropriate interest rates.
To analyze the optimal debt ratio for a private firm, we make the following adjustments. First, we
estimate the value of the private firm by looking at how publicly traded firms in the same business are
priced by the market. Thus, if publicly traded firms in the business have market values that are roughly
three times revenues, we would multiply the revenues of the private firm by this number to arrive at an
estimated value. Second, we continue to estimate the costs of debt for a private firm using a synthetic
bond rating, based on interest coverage ratios, but we will require much higher interest coverage ratios
to arrive at the same thing, to reflect the fact that banks are likely to be more conservative in assessing
default risk at small, private firms. Finally, we will use total betas to capture total risk, rather than just
market risk, to estimate the cost of equity.
 


$
 
*

h

 
Although the trade-off between the costs and benefits of borrowing remain the same for private and
publicly traded firms, there are differences between the two kinds of firms that may result in private
firms borrowing less money.
! Increasing debt increases default risk and expected bankruptcy costs much more substantially
for small private firms than for larger publicly traded firms. This is partly for the reason that the
owners of private firms may be exposed to unlimited liability, and partly for the reason that the
perception of financial trouble on the part of customers and suppliers can be much more
damaging to small, private firms.
! Increasing debt yields a much smaller advantage in terms of disciplining managers in the case of
privately run firms, for the reason that the owners of the firm tend to be the top managers as
well.
! Increasing debt generally exposes small private firms to far more restrictive bond covenants and
higher agency costs than it does large publicly traded firms.
! The loss of flexibility associated with using excess debt capacity is likely to weigh much more
heavily on small, private firms than on large, publicly traded firms, due to the former͛s lack of
access to public markets.
All these factors would lead us to expect much lower debt ratios at small private firms.

h 
ã
 h
There are several problems in applying the cost of capital approach to financial service firms, such as
banks and insurance companies. The first is that the interest coverage ratio spreads, which are critical in
determining the bond ratings, have to be estimated separately for financial service firms; applying
manufacturing company spreads will result in absurdly low ratings for even the safest banks and very
low optimal debt ratios. Furthermore, the relationship between interest coverage ratios and ratings
tend to be much weaker for financial service firms than it is for manufacturing firms. The second is a
measurement problem that arises partly from the difficulty in estimating the debt on a financial service
company͛s balance sheet. Given the mix of deposits, repurchase agreements, short-term financing, and
other liabilities that may appear on a financial service firm͛s balance sheet, one solution is to focus only
on long-term debt, defined tightly, and to use interest coverage ratios defined using only long-term
interest expenses. The third problem is that financial service firms are regulated and have to meet
capital ratios that are defined in terms of book value. If, in the process of moving to an optimal market
value debt ratio, these firms violate the book capital ratios, they could put themselves in jeopardy.
While we could try to adapt the cost of capital approach to come up with optimal debt ratios for banks
and other financial service companies, the results are very sensitive to how we define debt and the
relationship we assume between bond ratings and operating income. An alternative and more effective
approach is to use the regulatory capital ratios, usually determined in terms of book equity, as the basis
of regulatory capital ratios, usually determined in terms of book equity, as the basis of determining how
much equity a financial service firm needs to raise to not only continue operating, but to do so without
putting itself at peril. As a simple example, consider a bank with TZS 100 million in loans outstanding and
a book value of equity of TZS6 million. Furthermore, assume that the regulatory requirement is that
equity capital be maintained at 5 percent loans outstanding. Finally, assume that this bank wants to
increase its loan base by TZS50 million to TZS 150 million and to augment its equity capital ratio to 7
percent of loans outstanding. The amount of equity that the bank will have to raise to fund its expansion
is computed below:
Loans outstanding after Expansion M TZS150 million
Equity/Capital ratio desired M 7 percent
Equity after expansion M TZS10.5 million
Existing Equity M TZS6.0 million
New Equity needed M TZS4.5 million
As we look at more complex financial service firms that operate in multiple businesses with different risk
levels, there are two challenges that we will face in putting this approach into practice:
a. 

 

 

%

   
 

  $
  : When a firm operates in
different businesses, the regulatory capital restrictions can vary across businesses. In general,
the capital requirements will be higher in riskier businesses and lower in safer businesses.
Hence, the equity that a firm has to raise to fund expansion will depend in large part of which
business are being expanded.
b. 
 
A$ 

 The regulatory ratios represent a floor on what a firm
has to invest in equity, to keep its operations going and not a ceiling. It is possible that the firm͛s
own assessment of risk in a business can lead it to hold more equity than required by the
regulatory authorities.
As a final twist, it is worth nothing that banking regulators consider preferred stock as part of
equity, when computing regulatory ratios. In general, there are three strategies that a financial
service firm can follow when it comes to the use of leverage:
! 





: In this strategy, financial service firms try to stay with
the bare minimum equity capital, as required by the regulatory ratios. In the most
aggressive versions of this strategy, firms exploit loopholes in the regulatory framework
to invest in those businesses where regulatory capital ratios are set too low (relative to
the risk of these businesses). The upside of this strategy is that the returns on equity in
good times will exceptionally high, since the equity capital is kept low. The downside of
this strategy is that the risk in the investment ultimately will manifest itself and the
absence of equity to cover losses will put the firm͛s existence in jeopardy.
! The Self-regulatory strategy: The objective for a bank raising equity is not to meet
regulatory capital ratios but to ensure that losses from the business can be covered by
the existing equity. In effect, financial service firms can assess how much equity they
need to hold by evaluating the riskiness of their businesses and the potential for losses.
Having done so, they can then check to also make sure that they meet the regulatory
requirements for capital. The upside of this strategy is that it forces the firm to both
assess risk in its businesses and to make the trade off between risk and return, when
entering new business. The downside is that it is more data intensive, and errors in
assessing risk will affect the firm͛s value.
! Combination strategy: In this strategy, the regulatory capital ratios operate as a floor for
established business, with the firm adding buffers for safety where needed. In new or
evolving businesses, the firm makes its own assessments of risk that may be very
different from those made by the regulatory authorities.
We would argue that the responsibility for maintaining enough equity has to rest ultimately with the
management of the firm and not with the regulatory authorities. A bank that blames the laxness of
regulatory oversight for its failures is not a well-managed bank.


  
$

The preceding analysis highlights some of the determinants of the optimal debt ratio. We can then
divide these determinants into firm-specific and macroeconomic factors.
hã h  
The optimal debt ratios that we compute will vary across firms. There are three firm specific factors that
contribute to these differences ʹ the tax rate of the firm, its capacity to generate cash flows to cover
debt payments and uncertainty about future income.
! 
" ! á
: In general, the tax benefits from debt increase as the tax rate goes up. In
relative terms, firms with higher tax rates will have higher optimal debt ratios than do firms with
lower tax rates, other things being equal. It also follows that a firm͛s optimal debt ratio will
increase as its tax rate increases.
! 

! á

  
 
 +    

,: The most significant determinant of the
optimal debt ratio is a firm͛s earnings capacity. In fact, the operating income as a percentage of
the market value of the firm (debt plus equity) is usually good indicator of the optimal debt
ratio. When this number is high (low), the optimal debt ratio will also be high (low). A firm with
higher pretax earnings can sustain much more debt as a proportions of the market value of the
firm, for the reason that debt payments can be met much more easily from prevailing earnings.
! 

R

 O 
The variance in operating income enters the base case analysis in
two ways. First, it plays a role in determining the current beta: Firms with high (low) variance in
operating income tend to have high (low) betas. Second, the volatility in operating income can
be one of the factors determining bond ratings at different levels of debt: Ratings drop off much
more dramatically for higher variance firms as debt levels are increased. It follows that firms
with higher (lower) variance in operating income will have lower (higher) optimal debt ratios.
The variance in operating also pays a role in the constrained analysis, for the reason that higher-
variance firms are much more likely to register significant drops in operating income.
Consequently, the decision to increase debt should be made much more cautiously for these
firms.
   h  
Should macroeconomic conditions affect optimal debt ratios? In purely mechanical terms, the answer is
yes. In good economic times, firms will generate higher earnings and be able to service more debt. In
recessions, earnings will decline and with it the capacity to service debt. That is why prudent firms
borrow based on normalized earnings rather than current earnings. Holding operating income constant,
macroeconomic variables can still affect optimal debt ratios. In fact, both the level of risk-free rate and
the magnitude of default spreads can affect optimal debt ratios.
!

 á
: As interest rates decline, the conventional wisdom is that debt should become
cheaper and more attractive for firms. Though this may seem intuitive, the effect is muted by
the fact that lower interest rates also reduce the cost of equity. In fact, changing the risk-free
rate has a surprisingly small effect on the optimal debt ratio as long as interest rates move
within a normal range. When interest rates exceed normal levels, optimal debt ratios do decline
partly for the reason that we keep operating income fixed. The higher interest payments at
every debt ratio reduce bond ratings and affect the capacity of firms to borrow more.
! 
  

 The default spreads for different ratings classes tend to increase during
recessions and decrease during economic booms. Keeping other things constant, as the spreads
increase (decrease) optimal debt ratios decrease (increase), for the simple reason that higher
spreads penalize firms that borrow more money and have lower ratings. In fact, the default
spreads on corporate bonds declined between 2002 and 2007, leading to higher optimal debt
ratios for all firms. In 2008, as the economy slowed and the market entered crisis mode, default
spreads widened again, leading to lower optimal debt ratios.
 There is another factor to consider. The same factors that cause default spreads to increase and
decrease also play a role in determining equity risk premiums. Hence, the question of how much
changing default spreads affect optimal debt ratios cannot be answered without looking at how
much equity risk premiums also change. If equity risk premiums increase more than default
spreads do, debt will become a more attractive choice relatively to equity.
¢& *
  9¢
 
In the adjusted present value (APV) approach, we begin with the value of the firm without debt.
As we add debt to the firm, we consider the net effect on value by considering both the benefits
and the costs of borrowing. The value of the levered firm can then be estimated at different
levels of the debt, and the debt level that maximizes firm value is the optimal debt ratio.
ã 
 ¢*9¢
 
In the APV approach, we assume that the primary benefit of borrowing is a tax benefit and that
the most significant cost of borrowing is the added risk of bankruptcy. To estimate the value of
the firm with these assumptions, we proceed in three steps. We begin by estimating the value of
the firm with no leverage. We then consider the present value of the interest tax savings
generated by borrowing a given amount money. Finally, we evaluate the effect of borrowing the
amount on the probability that the firm will go bankrupt and the expected cost of bankruptcy.
Step 1: Estimate the value of the firm with no debt: The first step in this approach is the
estimation of the value of the unlevered firm. This can be accomplished by valuing the firm as if
it had no debt, that is, by discounting the expected after-tax operating cash flows at the
unlevered cost of equity. In the special case where cash flows grow at a constant rate in
perpetuity,
'  c  0
  0400| ;  &
where FCFF1 is the expected after-tax operating cash flow to the firm in the next period, ʌu is
the unlevered cost of equity, and  is the expected growth rate. The inputs needed for this
valuation are the expected cash flows, growth rates, and the unlevered cost of equity. To
estimate the latter, we can draw on our earlier analysis and compute the unlevered beta of the
firm:
  
  
  
 ||& 
$
 

Where ɴunlevered M unlevered beta of the firm, ɴcurrent M current equity beta of the firm, M tax rate
for the firm, and D/E M current debt/equity ratio. This unlevered beta can then be used to arrive
at the unlevered cost of equity. Alternatively, we can take the current market value of the firm
as a given and back out the value of the unlevered firm by subtracting out the tax benefits and
adding back the expected bankruptcy cost from the existing debt.
Current Firm Value M Value of Unlevered firm + PV of Tax renefits ʹ Expected rankruptcy Costs
Value of Unlevered Firm M Current Firm Value ʹ PV of Tax renefits + Expected rankruptcy Costs
Step 2: Estimate the present value of tax benefits from debt: The second step in this approach is the
calculation of the expected tax benefit from a given level of debt. This tax benefit is a function of the tax
of the firm and is discounted at the cost of debt to reflect the riskiness of this cash flow. If the tax
savings are viewed as a perpetuity.
Value of Tax renefits M [Tax Rate * Costs of Debt * Debt]/Cost of Debt
M Tax Rate * Debt
M cD
The tax rate used here is the firm͛s marginal tax rate, and it is assumed to stay constant over time. If we
anticipate the tax rate changing over time, we can still compute the present value of tax benefits over
time, but we cannot use the perpetual growth equation.
Step 3: Estimate the expected bankruptcy costs as a result of the debt: The third step is to evaluate the
effect of he given level of debt is to evaluate the effect of the given level of debt on the default risk of
the firm and on expected bankruptcy costs. In theory, at least, this requires the estimation of the
probability of default with the additional debt and the direct and indirect cost of bankruptcy. If ʋa is the
probability of default after the additional debt and rC is the present value of the bankruptcy cost the
present value of the expected bankruptcy cost can be estimated. Ͷ
M ʋar
This step of the APV approach poses the most significant estimation problem, for the reason that
neither the probability of bankruptcy nor the bankruptcy cost can be estimated directly. There are two
ways the probability of bankruptcy can be estimated indirectly. One is to estimate a bond rating, as we
did in the cost of capital approach, at each level of debt and use the empirical estimates of default
probabilities for each rating. For instance, Table 4.13, extracted from an annually updated study by
Altman, summarizes the probability of default over ten years by bond rating class.
Table 4.13: Default Rates by rond Rating Classes
Rating Likelihood of Default
AAA 0.07 %
AA 0.51 %
A+ 0.60 %
A 0.66 %
Aʹ 2.50 %t
rrr 7.54 %
rr 16.63 %
r+ 25.00 %
r 36.80 %
rʹ 45.00 %
CCC 59.01 %
CC 70.00 %
C 85.00 %
D 100.00 %
The other is to use a statistical approach, such as a profit to estimate the probability of default, based on
the firm͛s observable characteristics, at each level of debt.
The bankruptcy cost can be estimated, albeit with considerable error, from studies that have looked at
the magnitude of this cost in actual bankruptcies. Studies that have looked at the direct cost of
bankruptcy conclude that they are small relative to firm value. The indirect costs of bankruptcy can be
substantial, but the costs vary widely across firms. Shapiro and Titman speculate that the indirect costs
could be as large as 25 to 30 percent of firm value but provide no direct evidence of the costs.
The net effect of adding debt can be calculated by aggregating the cost and the benefits at each level of
debt.
Value of Levered Firm M FCFF1/(ʌu ʹ g) + tc ʹ ʋar
We compute the value of the levered firm at different levels of debt. The debt level that maximizes the
value of the levered firm is the optimal debt ratio.
r 
  


  ¢*9¢
 
The advantage of the APV approach is that it separates the effects of debt into different components
and allows an analyst to use different discount rates for each component. In this approach, we do not
assume that the debt ratio stays unchanged forever, which is an implicit assumption in the cost of
capital approach. Instead, we have the flexibility to keep the money value of debt fixed and to calculate
the benefits and costs of the fixed money debt.
These advantages have to be weighed against the difficulty of estimating probabilities of default and the
cost of bankruptcy. In fact, many analyses that use the APV approach ignore the expected bankruptcy
costs, leading them to the conclusion that firm value increases as firms borrow money. Not surprisingly,
they conclude that the optimal debt ratio for a firm is 100 percent debt.
In general, with the same assumptions, the APV and the cost of capital conclusions give identical
answers. Nevertheless, the APV approach is more practical when firms are evaluating the feasibility of
adding an amount of debt, whereas the cost of capital approach is easier when firms are analyzing debt
proportions.


¢ 

The most common approach to analyzing the debt ratio of a firm is to compare its leverage to that of
similar firms. A simple way to perform this analysis is to compare a firm͛s debt ratio to the average debt
ratio for the industry in which the firm operates. A more complete analysis would consider the
differences between a firm and the rest of the industry, when determining debt ratios. We will consider
both ways below.
  
 
 ¢


Firms sometimes choose their financing mixes by looking at the average debt ratio of other firms in the
industry in which they operate. The underlying assumptions in this comparison are that firms within the
same industry are comparable and that, on average, these firms are operating at or close to their
optimal. roth assumptions can be questioned, nevertheless. Firms within the same industry can have
different product mixes, different amounts of operating risk, different tax rates, and different project
returns. In fact, most do.
 


  i   h
Firms within the same industry can exhibit wide differences on tax rates, capacity to generate operating
income and cash flows, and variance in operating income. Consequently, it can be dangerous to
compare a firm͛s debt ratio to the industry and draw conclusions about the optimal financing mix. The
simplest way to control for differences across firms, while using the maximum information available in
the market, is to run a regression, regressing debt ratios against these variables, across the firms in an
industry:
Debt Ratio M ɲ0 + ɲ1 Tax Rate + ɲ2 Pretax Returns + ɲ3 Variance in Operating Income
There are several advantages to the cross-sectional approach. Once the regression has been run and the
basic relationship established (i.e., the intercept and coefficients have been estimated), the predicted
debt ratio for any firm can be computed quickly using the measures of the independent variables for this
firm. If a task involves calculating the optimal debt ratio for a large number of firms in a short time
period, this may be the only practical way of approaching the problem, for the reason that the other
approaches described in this chapter are time-intensive.
There are also limitations to this approach. The coefficients tend to shift over time. resides some
standard statistical problems and errors in measuring the variables, these regressions also tend to
explain only a portion of the differences in debt ratios between firms. Nevertheless, the regressions
provide significantly more information than a naive comparison of a firm͛s debt ratio to the industry
average.

" *¢ "9""h¢*¢ ãcc"

The ͞capital structure puzzle͟ i.e., the firm͛s choice of an optimal capital structure, remains one of the
large unresolved issues in the financial economics literature. The origin for five decades of capital
structure research is provided by Modigliani and Miller (1958). They argue that in a neoclassical world
capital structure decisions are irrelevant for the market value of a firm (MM theory). Nevertheless, the
MM-theory builds on the restrictive assumptions of perfect and complete capital markets with rational
investors.
Consequently, further research subsequently enhanced the field of capital structure theory by
accounting for several market imperfections. Modigiliani and Miller (1963) themselves started to extend
their MM-theory by introducing taxes and costs of financial distress. The static ͞trade-of theory͟ of
capital structure assumes the existence of a target debt ratio where the marginal cost of an additional
unit of debt, i.e., the costs of financial distress, equal the marginal benefits of an additional unit of debt,
i.e., the tax shield. In other words, according to this theory management aims to establish an optimal
capital structure which is determined by a trade-off between the costs and benefits of borrowing debt.
In contrast, the second major capital structure theory is based on a dynamic perspective of investment
opportunities and information asymmetries. The ͞pecking order theory͟ of capital structure assumes
that firms prefer to finance growth opportunities with internal funds, debt, preferred equity and
common equity, in that order. rehind the pecking order theory is the rationale that information
asymmetries between the informed firm insiders and uninformed outside investors lead to a mispricing
of equity issues. Hence, the decisions of the management are driven by the desire to minimize
transaction costs. Hence, the decisions of the management are driven by the desire to minimize
transaction costs. Despite the dominance of those two paradigms in the discussion of capital structure
theory, several authors have proposed further determinants of capital structure decisions: Among them
are signaling aspects, corporate control considerations, market timing issues and firm history.
In this discussion, we focus on another major determinant for capital structure decisions: agency costs.
In particular, we compare two distinct groups of firms that are considered to be unequal in terms of
agency costs: family firms and non-family firms. rased on the widespread assumption that agency costs
are lower in family firms, we would expect that there is less need for the disciplining role of debt in
family firms and that they hence have lower leverage ratios. Nevertheless, existing economies, such as
the United States. While Mishra and McConaughy (1999) conclude that U.S. family firms use less debt to
avoid a loss of control and decrease the likelihood of bankruptcy, Anderson and Reeb (2003b) find no
systematic difference between U.S. family and non-family firms in terms of leverage. Finally, just
recently Ellul (2008) finds a positive relationship between leverage and family blockholdings based on a
cross-country analysis. Nevertheless, to our best knowledge detailed empirical evidence from a bank-
based economy is missing so far. The importance of the institutional setting for capital structure
decisions is stressed by Antoniou et al. (2008) who argue that ͞the capital structure of a firm is heavily
influenced by the economic environment and its institutions, corporate governance practices, tax
systems, the borrower-lender relation, exposure to capital markets, and the level of investor protection
in the country in which the firm operates.͟
This discussion builds on this research gap and aims to shed more light on hitherto conflicting empirical
results by analyzing capital structure decisions in family firms within a bank-based economy in greater
detail. The country of our choice ʹ Tanzania ʹ seems to provide a very fruitful research environment
since it is characterized by the following stylized facts: (i) a different legal and institutional setting and
underdeveloped stock markets in comparison to anglo-saxon countries, (ii) a bank-orientated financial
system with widespread relationship lending, (iii) a tradition where family firms are considered to be the
backbone of the economy and (iv) still concentrated ownership patterns with a large amount of family
firms even among listed companies.
Starting from these conflicting observations, it is by far not clear whether family firms in Tanzania use
more or less dent and what factors drive their capital structure decisions. Moreover, it is an open
question how the different components of a family firm, namely founding family ownership, supervisory
and management board participation, affect those capital structure decisions. The focus of our
discussion is to analyse these in greater detail. Thereby, we contribute to the literature in several
important dimensions: First, to our best knowledge our empirical study is the first to analyse capital
structure decisions of family firms for a bank-based economy. This is interesting against the background
that Tanzania differs largely from the U.S. in terms of institutional setting. We complement recent albeit
inconsistent empirical evidence on capital structure decisions of family firms that is so far largely
focusing on the U.S. Second, in terms of methodology our analysis is more advanced that previous
research on capital structure decisions within family firms. We do not only exploit cross-sectional
heterogeneity with ͞between͟ estimates and pooled OLS regressions but also time variation based on
͞within͟ estimates. Those firm fixed effects models allow us to control for unobserved firm
heterogeneity. Finally, we employ a battery of robustness tests including a matching estimator that
allows us to control for issues of endogeneity. Our results are highly robust and not subject to any
special kind of methodology. Third, we investigate an aspect that goes beyond existing research on
family firms: We carefully analyse the impact of different family firm characteristics on capital structure
decisions. In particular, we distinguish between three separate components of a family firm, i.e., family
ownership, family supervisory and management board participation. In fact, that distinction allows us to
show that firm leverage heavily depends on agency costs. From these three aspects the convergence-of-
interest effect of family management seems to have the strongest (negative) influence on leverage
ratios. In the case of combined family ownership and management board participation, in other words if
the founding family is a large shareholder with monitoring incentives and simultaneously involved in
firm management with convergence-of-interest effects between management and outside
shareholders, agency costs and hence firm leverage are the lowest. This outcome underlines the
importance of agency costs theory in family firm research. Moreover, in accordance with several
previous performance studies we detect a significant impact of founder CEO on capital structure
decisions. Our fourth contribution is related to the analysis of capital structure in Tanzania. In general
empirical evidence on this topic based on a large sample of listed firms in Tanzania is rather limited.



 


 
Following the extant body of literature on listed family firms, our definition of a family firm is based on
two components: the ownership and management component. In particular, we classify a firm within
our sample as a family firm if at least one of the following three conditions is satisfied: (i) the founding
family has voting rights of at least 25 percent (family ownership) and/or (ii) at least one member of the
founding family is represented in the supervisory board (supervisory board participation) (iii) at least
one member of the founding family is involved in top management (management board participation).
The fact that we use 25 percent of voting rights as ownership threshold is related to the typically more
concentrated ownership structures in continental Europe. Moreover, 25 percent compromises an
important control threshold according to the German stock corporation act.13 Of course, if a company
was founded by a team of entrepreneurs, the term founding family might refer to more than one family.
rased on this definition we have created a dummy variable called Family Firm which is one if the firm
qualifies as a family business according to our definition and zero otherwise. Overall, our sample
consists of 660 firms and 5,135 firm year observations: 2,410 family firm year observations and 2,725
non-family firm year observations. For an overview of the sample composition over time cf. table 4.14.
$303

 ã
Year Firms Family Non-
Firms Family
Firms
1995 230 65 165
1996 235 68 167
1997 250 75 175
1998 312 111 201
 1999 430 203 227
2000 566 312 254
2001 568 315 253
2002 542 278 264
2003 514 262 252
2004 500 248 252
2005 494 237 257
2006 494 236 258
: This table shows the development of the sample composition over time. Column 1 presents the 12 sample years between
1995 and 2006, column 2 the number of firms in each year and column 3 and 4 the number of family and non-family firms in
each year.

In a second step, we test whether differences in capital structure are driven by family ownership or
family management. Therefore, we substitute the dummy variable family firm in all our regression
models by three variables: (i) family ownership, (ii) supervisory board participation and (iii) management
board participation. Family ownership is the cumulated ownership fraction of the founding family.
Supervisory board participation is a dummy variable with unit value one if a member of the founding
family is part of the supervisory board. The same dummy variable is constructed for management board
participation. Finally we run all regressions with two other specifications: First, we analyse the impact of
the firm͛s CEO. Several other studies, e.g. Anderson and Reeb (2003a) or Villalonga and Amit (2006),
argue that the identity of the CEO is of special importance for the firm͛s corporate policy and
performance. Following those studies, we construct a dummy variable called founder CEO that takes
unit value one if the founder is still running the firm as CEO and zero otherwise. Second, we interact
family ownership and management participation. The interaction term allows us to investigate the
hypothesis that the effect of agency costs on capital structure is strongest if the founding family is
simultaneously a large shareholder and involved in running the firm͛s daily business.


 

We measure leverage in several ways:
(i) We start with a broad definition of book and market leverage. rook leverage is the ratio of
total liabilities to total assets while the market leverage is the ratio of total liabilities to the
market value of equity plus total liabilities. Thereby, we treat preferred equity as equity rather
than debt. ry applying such a broad definition of leverage we follow several other studies on
capital structure. Moreover, just recently Elsas and Florysiak (2008) have applied similar
definitions of leverage for a large sample study of capital structure in the German
environment. This broad definition includes non-interest-bearing debt components, such as
pension liabilities or accounts payable, and is likely to overestimate financial leverage.
Although such a definition is not a very good indication for the future default probability, for
many firms those non-interest-bearing debt components are important parts of their capital
structure.
(ii) We run all regression models with a definition of long-term leverage. Long-term book leverage
is defined as total liabilities minus current liabilities divided by total assets. Accordingly, long-
term market leverage is defined as total liabilities minus current liabilities to market value of
equity plus total liabilities.
(iii) Finally, we calculate a financial leverage that only considers interesting-bearing debt
components. Our measure for the book value of financial leverage is calculated as total
liabilities minus the sum of accounts payable, provisions for risks and charges (including
pension liabilities) and deferred taxes divided by total assets minus the sum of accounts
payable, provisions for risks and charges (including pension liabilities) and deferred taxes. As
 in the two other measures of leverage, we replace the book value of equity with the market
value of equity when we calculate the market value of financial leverage.



  


$

In our analysis, we use a set of control variables (for a detailed overview of all variables cf. table 4.15).
Frank and Goyal (forthcoming) show that there are six core factors that can explain firm leverage for
publicly traded American companies over the period 1950 to 2003: Firm size, profitability, market-to-
book ratio, tangible assets ratio, median industry leverage and expected inflation. We include all these
factors, which are described below, in our analysis.
Since we already use total assets to scale our dependent variable, we use the natural logarithm of the
number of employees to control for firm size (FIRM SIZE). Firm size is included in all specifications to
account for the fact that larger firms have a higher creditworthiness, easier access to debt markets and
might be able to borrow at lower costs. Moreover, larger firms might use their financing-mix to
maximize tax benefits. Overall, we anticipate a positive relation between firm size and leverage. Family
firms might experience lower agency costs of free cash flow and depend more on internal financing. We
use an operating profit margin calculated as earnings before interest, taxes, depreciation and
amortization divided by total assets (PROFITArILITY) as a proxy for firm profitability. The pecking order
theory suggests that firms prefer to finance new investment projects with retained earnings followed by
new debt while issuing external equity is only the last resort of financing. Consequently, we expect an
inverse relationship between the firm profitability and the leverage ratio. We control for the firm͛s
growth options by including the market-to-book ratio (MARKET-TO-rOOK) into our regressions.
Information asymmetries may lead firms to issue equity instead of debt if they have NPV-positive
projects (Myers 1977). Furthermore, firms may prefer to retain earnings instead of distributing them if
they have valuable growth options. Hence, we expect market-to-book ratio to be negatively related to
leverage. We include the ratio of tangible assets to totals assets (TANGIrLE ASSETS RATIO) in our
analysis to account for the fact that tangible assets function as collateral and hence increase borrowing
capacity. We expect the tangibility ratio to be positively correlated to the firm͛s leverage.
The median industry leverage (MEDIAN INDUSTRY LEVERAGE) is included as a control for industry
originalities. Firms operating in highly levered industries are expected to exhibit higher leverage ratios.
For example, Frank and Goyal (forthcoming) show that the industry median leverage ratio has the single
largest explanatory power for the firm-level leverage in their long-term dataset on U.S. firms. Although
we use industry dummies to control for industry effects in general, we therefore include industry
median leverage in our regressions as an additional control variable. This measure is calculated for each
industry and year, whereby the firm͛s industry classification is based on its one-digit primary SIC-Code.
Of course, we expect industry leverage to have a positive impact on firm leverage. The expected
inflation rate (EXPECTED INFLATION RATE) is another variable with high explanatory power for leverage
ratios. We anticipate firms to show higher levels of leverage if the expected inflation rate is high since
debt becomes more attractive in these time periods. In our analysis, we use the next year͛s realised
inflation rate as a proxy for the expected inflation rate. In order to investigate if this adoption leads to
biased results, we applied the one-year inflation rate forecast of the German ͞Sachverständigenrat͟ as
an alternative measure of expected inflation (results not reported). Nevertheless, the results for these
two measures are qualitatively the same. resides these control factors proposed by Frank and Goyal
(2009) we include several additional variables in our regressions, which are described below.
The dividend payout ratio (PAYOUT RATIO) is likely to play an important role for the firm͛s financing mix.
For example, Rozeff (1982) predicts an inverse relationship between dividend payout and leverage due
to agency costs and transaction costs arguments. Also if dividends are considered to be a signal for
future earnings, firms with high dividend payout ratios face lower cost of equity. They might prefer
equity instead of debt and hence we expect a negative relationship between the firm͛s dividend payout
ratio and the firm͛s leverage.
Nevertheless, we adopt the payout ratio as suggested by Julio and Ikenberry (2004) and von Eije and
Megginson (2008): We set the payout ratio to 1 if it is negative (for the reason that of negative income)
or above one. Firm age (FIRM AGE) is the natural logarithm of the number of years since the firm͛s
incorporation. Thereby, the number of years since the firm͛s incorporation is calculated as the current
sample year minus the founding year of the firm. We expect younger firms ceteris paribus to have better
growth options than older firms. Younger firms might be more reliable on equity instead of debt and
prefer to retain earnings within the firm to finance their growth options. Simultaneously we hypothesize
that older firms have more tangible assets, a better borrowing capacity and are more profitable. Hence,
the expected relationship between firm age and leverage is positive.
One potential concern is that founding family ownership is not randomly assigned to different
industries. In particular, instead of applying risk-reducing strategies at the firm level, founder families
might prefer to invest in low-risk businesses and industries. Consequently, we include a measure of firm-
specific risk (FIRM SPECIFIC RISK). Firm-specific risk captures the part of stock prize volatility that is
unique to an individual firm and thus related to specific operations or capital structure decisions. It is
calculated as the residuals͛ sum of squares (SSE) from a regression of the individual stock returns on the
returns of the market (CDAX) over the preceding calendar year based on stock prizes from calendar year
end.
Since higher debt-to-equity ratios increase the firm͛s risk of default, we expect a positive relationship
between firm specific risk and leverage. Decisions about capital structure are dependent on the firm͛s
governance structure. Consequently, we include some corporate governance measures in our analysis.
Monitoring by outside shareholders might be an alternative to incentive alignment as a corporate
governance device in order to alleviate the classical shareholder-manager conflict. Hence, we include
the cumulative corporate ownership of large outside shareholders with an ownership stake of at least 5
percent in our analysis (OUTSIDE rLOCKHOLDERS). Alternatively, as indicated in our section about
robustness tests, we control for the presence of a second large shareholder besides the founding family.
In Germany, the sample period 1995 to 2006 is characterised by a huge heterogeneity in terms of
applied accounting standards. This is due to the introduction of the capital raising facilitating act
(Kapitalaufnahmeerleichterungsgesetz ʹ KapAEG) in 1998. According to this law, all listed German
consolidated companies have the possibility to prepare annual consolidated financial statements either
in IFRS/IAS (International Financial Reporting Standards or respectively International Accounting
Standards, henceforth IFRS) or USGAAP. Simultaneously they face no requirement to prepare additional
annual consolidated (not individual) financial statement in German GAAP if they apply IFRS or US-GAAP.
From 2005 onwards, the usage of IFRS is mandatory for consolidated companies according to § 315a
German GAAP. Hence, all firms change the applied accounting standard during the sample period. Since
the valuation of assets and liabilities is largely dependent on the application of a true-and-fair-view
accounting system (such as IFRS or US-GAAP) or a conservative accounting system (such as German
GAAP),18 we control for accounting systems with a dummy variable for the application of German GAAP
(DUMMY ACCOUNTING STANDARD). The dummy variable takes unit value one if the firm applies
German GAAP and is zero if the firm applies either IFRS or US-GAAP. Due to the principle of prudence in
German GAAP we expect a positive relationship between the usage of a conservative accounting system
and the leverage ratio.
Theory predicts that mature industries with less opportunity for asset substitution (Jensen and Meckling
1976) have higher leverage ratios. Hence, we use industry dummies based on one-digit SIC codes in all
our regressions to control for such industry specifics. Capital structure decisions might be subject to
macroeconomic and legal conditions. To control for such time effects we include year dummies in all our
analysis.
$301


 9

$

9

$
 9

$  



 

$
Corporate Governance Variable
Control Variables
Dummy Family Firm Dummy which is one if (a) the
cumulative ownership stake of
the founding family is at least 25
percent and/or (b) a member of
the founding family is
represented in either the
management or supervisory
board
Founding Family Ownership Percentage of stock ownership
held by all members of the
founding family
Family Management [Mr] Equals 1 if a member of the
founding family is involved in the
management board
Family Management [Sr] Equals 1 if a member of the
founding family is involved in the
management board
Founder CEO Equals 1 if the CEO is the
founder of the firm
Ownership*Management [Mr] Interaction term of founding
family ownership and family
management [Mr]
Firm Size [Ln] Ln of the firm͛s number of
employees
Profitability Earnings before interest, taxes,
depreciation and amortization
(ErITDA)/total assets
Outside rlockholders Stock ownership of outside block
owners (which have an
ownership stake of at least 5
percent)
Firm specific Risk Residuals͛ sum of squares from a
regression of the individual stock
returns on the returns of the
market
Firm Age [Ln] Ln of the number of years since
the firm͛s incorporation
Tangible Assets Ratio Tangible assets/Total assets
Market-to-rook Market value of the firm/book
value of the firm
Dummy Accounting Standard Equals 1 if the firm applies IFRS
or GAAP according to the
accounting standard of the
concerned country
Payout Ratio Common dividends/net income
available to common equity;
Equals 1 if calculated payout

Capital Structure Variables
Median Industry Leverage
Expected inflation Rate
Dummy High-Tech Firm
rook Leverage
Market Leverage
Long-term rook Leverage
Long-term Market Leverage
Financial rook Leverage
Financial Market Leverage
ratio is below 0 or above 1.
Median leverage in the firm͛s
industry indicated by the first
number of the SIC code for each
year (Leverage is defined as for
the dependent variable in each
model)
Inflation rate of the following
year
Equals 1 if the firm went public
during 1998 and 2000
Total liabilities/(rook value of
equity + total liabilities)
Total liabilities/(Market value of
equity + total liabilities)
(Total liabilities ʹ current
liabilities)/(rook value of equity
+ total liabilities)
(Total liabilities ʹ current
liabilities)/(Market value of
equity + total liabilities)
(Total liabilities ʹ provisions ʹ
accounts payable ʹ deferred
taxes)/ (rook value of equity +
total liabilities ʹ provisions ʹ
accounts payable ʹ deferred
taxes)
(Total liabilities ʹ provisions ʹ
accounts payable ʹ deferred
taxes)/(market value of equity +
total liabilities ʹ provisions ʹ
accounts payable ʹ deferred
taxes)

 


 

 
Table 14.6 presents descriptive statistics for all sample companies as well as the two subgroups family
and non-family firms. As the t-test of differences in means indicates there seem to be huge differences
among these two subgroups of firms. Family firms are smaller (in assets, sales and employees) and as a
result have smaller management and supervisory boards. They are younger both in terms of years since
incorporation and years since the Initial Public Offering. For example, family firms are on average 31
years old, in comparison to an average age of 72 years for non-family firms. Furthermore, several
differences in accounting based figures or accounting standard can be found.
Since our study focuses on differences in leverage, it is very interesting that the descriptive statistics
indicate that family firms have lower levels of leverage than their nonfamily counterparts. For example,
the mean (median) book leverage is 0.49 (0.5) for family firms in comparison to 0.62 (0.66) for non-
family firms. Similar differences occur for market leverage with 0.36 (0.39) for family firms in
comparison to 0.54 (0.53) for non-family firms. Statistically significant differences in similar magnitude
do also occur for long-term leverage and financial leverage indicating that there are large differences in
terms of capital structure between the two firm groups.
$308 


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 ¢h

  h
h

   Ah
h

 
.
 
¢  
  
    
    
  A 
Founding 17.90 0 37.71 40.05 0.63 0 29.25
Family
Ownership
[%]
Outside 33.73 20.3 15.23 5.50 50.0 51.0 ʹ16.97
rlockholders
[%]
Size 3.16 3 2.94 3 3.34 3 ʹ3.34
Management
roard
Size 7.56 6 5.32 3 9.54 8 ʹ11.58
Supervisory
roard
h

ã
+
 
Assets (in 2,998.08 142.74 996.62 74.67 4,757.64 310.49 ʹ3.30
million TZS)
Sales (in 2,501.35 167.39 1,121.77 80.38 3,735.04 369.07 ʹ3.24
million TZS)
Employees 11,373 1023 6,324 428 15,863 2159 ʹ2.65
Firm Age 52.97 28 31.18 15 72.42 74 ʹ10.79
IPO Age 14.62 6 5.91 4 22.38 11 ʹ12.34
¢ 



 
Probability ʹ0.07 0.11 0.10 0.09 ʹ0.27 0.11 ʹ1.19
Tangible 0.23 0.20 0.20 0.15 0.26 0.24 ʹ4.81
Assets Ratio
Market-to- 2.86 1.73 3.08 1.74 2.66 1.72 0.72
rook
Dummy 0.46 0.00 0.32 0.00 0.58 1.00 ʹ8.85
Accounting
Standard
Payout rate 0.27 0.00 0.22 0.00 0.32 0.19 ʹ5.11
  
9

$ 
rook 0.56 0.59 0.49 0.50 0.62 0.66 ʹ0.27
Leverage
Market 0.47 0.46 0.36 0.39 0.54 0.53 ʹ8.32
Leverage
Long-term 0.26 0.25 0.20 0.17 0.32 0.31 ʹ9.53
rook
Leverage
Long-term 0.22 0.20 0.16 0.12 0.26 0.25 ʹ9.59
Market
Leverage
Financial 0.48 0.48 0.43 0.41 0.51 0.53 ʹ4.18
rook
Leverage
Financial 0.35 0.37 0.28 0.33 0.39 0.41 ʹ3.88
Market
Leverage
: Accounting information is obtained from Thomson's Worldscope Database. Information on ownership structure is hand-
collected from the Hoppenstedt Stock Guide. The sample consists of all non-financial firms in the broadest German stock Index
(CDAX) between 1995 and 2006. Firms are classified as family firms if the founding family has an ownership stake of at least 25
percent and/or a member of the founding family participates in the management or supervisory board. ***, ** and * indicate
significance on the 1 percent-, 5 percent- and 10 percent-level respectively. The t-statistics are corrected for serial correlation.
A detailed definition of all variables can be found in table 4.15.

"



  



Our data structure is organised as an unbalanced panel of 660 firms that are tracked over the 1995 to
2006 period. The panel structure of our data allows us to present three types of regression estimates:
pooled OLS, ͞between͟ estimates and ͞within͟ estimates. From an econometric point of view, all three
estimates have advantages and disadvantages. ͞retween͟ estimates are OLS estimates of firm means
across time. ͞Within͟ estimates are OLS estimates of deviations from the firm means across time (also
called fixed effects model since they include firm-fixed effects). While the ͞between͟ estimates only
employs cross-sectional variation, the ͞within͟-estimates only uses variation over time within each
section. The pooled OLS estimator combines both aspects as it is a weighted average of both the
͟between͟ and ͟within͟ estimators. ry reporting all three models, we follow earlier work on capital
structure by rerger et al. (1997) in terms of methodology and try to show that our results are robust
against several different estimation techniques.
Thereby, the fixed-effects estimator has one strong advantage: It offers the possibility to control for
unobserved, time-invariant firm heterogeneity. A recent study by Lemmon et al. (2009) indicates that
the adjusted R-squares of leverage regressions with firm fixed effects are much higher than the adjusted
R-squares from traditional leverage regressions. Hence, such firm fixed effects seem to have a high
explanatory power for capital structure decisions. Nevertheless, in our context the results of the fixed-
effects estimator have to be interpreted with caution since the ownership and board structures among
listed German firms are rather stable and thus offer little potential to exploit variation over time. As a
consequence, the results for these estimations may be driven by variations in few firm-year
observations. Consequently, it is useful to exploit cross-sectional variance by the ͞between͟ and pooled-
OLS estimates as well. In addition, ͞between͟ estimates allow to mitigate concerns that observations
drawn repeatedly from the same sample are independent from each other. Contrary to the ͞within͟
estimates, pooled OLS and ͞between͟ estimates may be biased if unobservable, time-invariant firm-
specific factors exist, leading to a correlation of the error term with the independent variables. This
happens if our models fail to include all relevant explanatory variables that are correlated with both the
regressors and the dependent variable. Since no single model combines all advantages, we decide to
report the estimates of all three models (OLS, ͞between͟ and ͞within͟ estimates).
In the context of panel datasets it is essential to estimate the standard errors in a correct way as
indicated by Petersen (2009). As suggested by him, we calculate the standard errors in the pooled-OLS-
specifications and the ͞within͟-estimates using the cluster-robust VCE estimator (this is not necessary
for the ͞between͟ estimates since there is only one observation per firm and hence no time-series
correlation). Our calculation includes adjustment for non-i.i.d. distributed standard errors, resulting both
from heteroskedasticity (Huber-White standard errors, cf. White 1980) and time-series correlation.
Finally, we calculate variance inflation factors (VIFs) to detect any multicollinearity problem.
Nevertheless, the calculated (not reported) VIFs indicate that our variables are not subject to any issues
of multicollinearity.
ãh¢*¢ ¢** ¢ã
The cost of capital is the expected rate of return that the market participants require in order to attract
funds to a particular investment. In economic terms, the cost of capital for a particular investment is an
opportunity cost Ͷ the cost of forgoing the next best alternative investment. In this sense, it relates to
the economic principle of substitution; that is, an investor will not invest in a particular asset if there is a
more attractive substitute.
The term market refers to the universe of investors who are reasonable candidates to fund a particular
investment. Capital or funds are usually provided in the form of cash, although in some instances capital
may be provided in the form of other assets. The cost of capital usually is expressed in percentage
terms, that is, the annual amount of dollars that the investor requires or expects to realize, expressed as
a percentage of the amount of money invested.
Put another way:
Since the cost of anything can be defined as the price one must pay to get it, the cost of capital is the
return a company must promise in order to get capital from the market, either debt or equity. A
company does not set its own cost of capital; it must go into the market to discover it. Yet meeting this
cost is the financial market͛s one basic yardstick for determining whether a company͛s performance is
adequate.
As the quote suggests, most of the information for estimating the cost of capital for a business, security,
or project comes from the investment market. The cost of capital is always an expected (or forward
looking) return. Thus, analysis and would-be investors never actually observe the market͛s view as to
expected returns at the time of their investment. Nevertheless, we often form our views of the future by
analyzing historical market data.
As Roger Ibbotson put it, ͞The opportunity Cost of Capital is equal to the return that could have been
earned on alternative investments at a specific level of risk.͟ In other words, it is the competitive return
available in the market on a comparable investment, with risk being the most important component of
comparability.
The valuation process is one of analysis of expected returns and pricing of risk. The cost of capital is the
return appropriate for the expected level of risk in the expected returns. It is the price of risk. rut often
observed returns do not match expected returns. That is the essence or risk.
The cost of capital is the expected rate of return on some base value. That base value is measured as the
market value of an asset, not its book value, par value, or carrying value. For example, the yield to
maturity shown in the bond quotations in the financial press is based on the closing market price of a
bond, not on its face value. Similarly, the implied cost of equity for a company͛s stock is based on the
market price per share at which it trades, not on the company͛s book value per share of stock. The cost
of capital is estimated from market data. These data refer to expected returns relative to market prices.
ry applying the cost of capital derived from market expectations to the expected net cash flows (or
other measure of economic income) from the investment or project under consideration, the market
value can be estimated.
Keep in mind that we have talked about expectations including inflation. Assuming inflationary
expectations, the return an investor requires includes compensation for reduced purchasing power of
the currency over the life of the investment. Therefore, when the analyst or investor applies the cost of
capital to expected returns in order to estimate value, he or she must also include expected inflation in
those expected returns.
This obviously assumes that investors have reasonable consensus expectations regarding inflation. For
countries subject to unpredictable hyperinflation, it is sometimes more practical to estimate the cost of
capital in real terms rather than in nominal terms and apply it to expected net cash expressed in real
terms.
The essence of the cost of capital is that it is the percentage return that equates expected economic
income with present value. The expected rate of return in this context is called a discount rate. ry
discount rate, the financial community means an annually compounded rate at which each increment of
expected economic income is discounted back to its present value. A discount rate reflects both the
time value of money and risk. Therefore, in its totality it represents the cost of capital. The sum of the
discounted values of each future period͛s net cash flow or other measure of return equals the present
value of the investment, reflecting the expected amounts of return over the life of the investment. The
terms discount rate, cost of capital, and required rate of return are often used interchangeably.
The economic income referenced here represents total expected benefits. In other words, this economic
income includes increments of cash flow realized by he investor while holding the investment, as well as
proceeds to the investor upon liquidation of the investment. The rate at which these expected future
total returns are reduced to present value is the discount rate, which is the cost of capital (required rate
of return) for a particular investment.
Discount rate and capitalization rate are two distinctly different concepts. Discount rate equates to cost
of capital. It is a rate applied to all expected economic income to convert the expected economic income
stream to a present value.
A capitalization rate, nevertheless, is merely a divisor applied to one single element of the economic
income stream to estimate a present value. The only instance in which the discount rate is equal to the
capitalization rate is when each future period͛s economic income is equal (i.e., no growth), and the
economic income is expected to continue into perpetuity. One of the few examples would be preferred
stock paying a fixed dividend amount per share into perpetuity.
ãc ¢;
The hypothesis of capital market efficiency has attracted a great deal of interest and critical comment.
This is somewhat surprising for the reason that capital market efficiency is a fairly limited concept. It
says that the prices of securities instantaneously and fully reflect all available relevant information. It
does not imply that product markets are perfectly competitive or that information is costless.
Capital market efficiency relies on the ability of arbitrageurs to recognize that prices are out of line and
to make a profit by driving them back to an equilibrium value consistent with available information.
Given this type of behavioral paradigm, one often hears the following sort of questions: If capital market
efficiency implies that no one can beat the market (i.e., make an abnormal profit), then how can
analysts be expected to exist since they, too, cannot beat the market? If capital markets are efficient,
how can we explain the existence of a multibillion dollar security analysis industry? The answer of
course, is that neither of these questions is inconsistent with efficient capital markets. First, analysts can
and do make profits. Nevertheless, they compete with each other to do so. If the point to analysis
becomes abnormally large, then new individuals will enter the analysis business until, on average, the
return from analysis equals the cost (which by the way, includes a fair return to the resources that are
employed). As shown by Cornell and Roll (1981), it is reasonable to have efficient markets where people
earn different gross rates of return for the reason that they pay differing costs for information.
Nevertheless, net of costs their abnormal rates of return will be equal (to zero).
The concept of capital market efficiency is important in a wide range of applied topics, such as
accounting information, new issues of securities, and portfolio performance measurement. ry and large
the evidence seems to indicate that capital markets are efficient in the weak and semistrong forms but
not in the strong form.
"9":<c"ãã
1. Suppose you know with certainty that the Clark Capital Corporation will pay a dividend of TZS10
per share on every January 1 forever. The continuously compounded risk-free rate is 5 percent
(also forever).
(a) Graph the price path of Clark Capital common stock over time.
(b) Is this (highly artificial) example a random walk? A martingale? A submartingale? (Why)?
2. Given the following situations, determine in each case whether or not the hypothesis of an
efficient capital market (semistrong form) is contradicted.
(a) Through the introduction of a complex computer program into the analysis of past stock
price changes, a brokerage firm is able to predict price movements well enough to earn a
consistent 3 percent profit, adjusted for risk, above normal market returns.
(b) On the average, investors in the stock market this year are expected to earn a positive
return (profit) on their investment. Some investors will earn considerably more than others.
(c) You have discovered that the square root of any given stock price multiplied by the day of
the month provides an indication of the direction in price movement of that particular stock
with a probability of .7.
(d) A securities and Exchange Commission (SEC) suit was failed against ArC Limited Company in
1965 for the reason that its corporate employees had made unusually high profits on
company stock that they had purchased after exploratory drilling had started in Dar es
Salam (in 1979) and before stock prices rose dramatically (in 1984) with the announcement
of the discovery or large mineral deposits in Dar es Salam.
3. The first national bank has been losing money on automobile consumer loans and is considering
the implementation of a new loan procedure that requires a credit check on loan applications.
Experience indicates that 82 percent of the loans were paid off, whereas the remainder
defaulted. Nevertheless, if the credit check is run, the probabilities can be revised as follows:
h
$ c 
$


  

 
Loan is paid .9 .5
Loan is defaulted .1 .5
An estimated 80 percent of the loan applications receive a favorable credit check. Assume that
the bank earns 18 percent on successful loans, loses 100 percent on defaulted loans, and suffers an
opportunity cost of 0 percent when the loan is not granted and would have defaulted. If the cost of a
credit check is 5 percent of the value of the loan and the bank is risk neutral, should the bank go ahead
with the new policy?
4. The Western Foods, one of the nation͛s largest consumer products firms, is trying to decide
whether it should spend TZS5 million to test market a new ready to eat product to proceed
directly to a nationwide marketing effort, or to cancel the product. The expected payoffs (in
million TZS) from cancellation versus nationwide marketing are given below:

¢
 
     
%
   
No acceptance 0 ʹ10
Marginal 0 10
 Success 0 80
Prior experience with nationwide marketing efforts has been:


 

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No acceptance .6
Marginal .3
Success .1
If the firm decides to test market the product, the following information becomes available:
  

  

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 .1 .7 .2
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For example, if the test market results predict a success, there is a 60 percent chance that the
nationwide marketing effort really will be a success but a 30 percent chance it will be marginal and a 10
percent chance it will have no acceptance.
(a) If the firm is risk neutral, should it test market the product or not?
(b) If the firm is risk averse with a utility function U(W) M in(W+11), should it test market the
product or not?
5. The efficient market hypothesis implies that abnormal returns are expected to be zero. Yet in
order for markets to be efficient, arbitrageurs must be able to force prices back into equilibrium.
If they earn profits in doing so, is this fact inconsistent with market efficiency?
6. (a) In a poker game with six players, you can expect to lose 83 percent of the time. How can this
still be a martingale?
b. In the options market, call options expire unexercised over 80 percent of the time. Thus the
option holders frequently lose all their investment. Does this imply that the options market is
not a fair game? Not a martingale? Not a submartingale?
7. If securities markets are efficient, what is the NPV of any security, regardless of risk?
8. State the assumptions inherent in this statement: A condition for market efficiency is that there
be no second-order stochastic dominance.

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@he Optimal Financing Mix
R
 
: To estimate the optimal mix of debt and equity for your firm and to evaluate the effect on
firm value of moving to that mix.
4
*
  
ͻ rased on the cost of capital approach, what is the optimal debt ratio for your firm?
rringing in reasonable constraints into the decision process, what would your recommended debt ratio
be for this firm?
ͻ Does your firm have too much or too little debt
- relative to the industry in which they operate?
- relative to the market?





-#     

ͻ What is the current cost of capital for the firm?
 ͻ What happens to the cost of capital as the debt ratio is changed?
ͻ At what debt ratio is the cost of capital minimized and firm value maximized? (If they
are different, explain.)
ͻ What will happen to the firm value if the firm moves to its optimal?
ͻ What will happen to the stock price if the firm moves to the optimal and stockholders
are rational?
1#r 
   



ͻ What rating does the company have at the optimal debt ratio? If you were to impose a
rating constraint, what would it be? Why? What is the optimal debt ratio with this rating
constraint?
ͻ How volatile is the operating income? What is the ͞normalized͟ operating income of
this firm, and what is the optimal debt ratio of the firm at this level of income?
'#á
 

ͻ Relative to the industry to which this firm belongs, does it have too much or too little in
debt? (Do a regression, if necessary.)
ͻ Relative to the rest of the firms in the market, does it have too much or too little in
debt? (Use the market regression, if necessary.)
%
    
 R
 
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To get the inputs needed to estimate the optimal capital structure, examine regulatory filings and the
annual report. The ratings and interest coverage ratios can be obtained from the ratings agencies (S&P,
Moody͛s), and default spreads can be estimated by finding traded bonds in each ratings class.
R
 

 
  
jjj.stern.nyu.edu/~adamodar/cfin2E/project/data.htm
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c

In general firms are free to choose the level of dividend they desire to pay to holders of ordinary shares,
even though factors such as legal requirements, debt covenants and the availability of cash resources
enforce some limitations on this decision. It is thus not astonishing that the experiential literature has
recorded regular variations in dividend behaviour in the firms, countries, time and type of dividend.

Variances between firms are noted, for instance, in Fama and French (2001). They bring substantiation
to show that US dividend firms tend to be big and cost-effective, while non-payers are typically small,
less profitable but with high investment opportunities. Variations throughout the countries comprise La
Porta, Lopez-de-Silanes, Shleifer and Vishny (2000) who study the dividend policies of over 4000 firms
from 33 countries around the world. It is established that dividend policies vary across legal regimes in a
way that is regular with the idea that dividend payment is the outcome of effective pressure by minority
shareholders to limit agency behavior. Therefore, firms in common law countries with good legal
protection of investors tend to have higher payout ratios compared with firms in countries with infirmer
legal protection. This is unfailing with Allen and Michaely (1995), who note that firms in the US, had
payout ratios of about 60 percent during 1980s and early 1990s. Nevertheless, during the same period,
Glen, Karmokolias, Miller and Shah (1995) observe an expenditure ratio of only about 40 percent, for a
composite of emerging markets͛ firms. Time trends in dividend behaviour is inquired by Fama and
French (2001), who find that the percentage of US firms that Pay dividends fell from 66.5 in 1978 to 20.8
percent in 1999. The study also depicts a declining trend in the propensity to pay dividend by US
corporations in the time period from the late 1970s to the late 1990s. Similarly DeAngelo and Skinner
(2000) look at time trends in the type of dividends paid by US firms. They find that special dividends
have gradually vanished in the period from the 1940s to the 1990s although incidents of very large
special dividends have increased.

In light of the freedom over dividend policy and the experiential variations across firms, countries, time
and type of dividends, the question of how dividend policy is determined has been the subject of
numerous studies. This question is often referred to as the dividend puzzle, and the debate is usually
believed to have been started by Miller and Modigliani͛s (1961) irrelevancy theory. Miller & Modigliani
(1961) show that in a perfect capital market with rational behaviour and perfect certainty and with
investment and borrowing decisions given, dividend policy has no effect on the value of the firm.4

4
Miller & Modigliani (1961) specify what they mean by perfect capital market, rational behavior and perfect
certainty. In a perfect capital market all buyers and sellers have equal access to information, and none receives
preferential treatment. Thus all traders are price-takers and none can affect the market price. Further, trading
does not entail any transaction costs and there are no tax differentials associated with paying dividends either for
firms or for individuals. Rational behavior implies that more wealth is preferred to less, and investors are
indifferent to whether wealth comes in the form of dividend or capital gains. Perfect certainty means that all
The value of the firm at the commencement of the period can be articulated as the dividend to be
received during the period plus the firm͛s value at the end of the period, less the amount of external
finance raised during the period, all expressed in present value terms. In turn, the amount of external
finance is the amount of funds required to finance planned investments, less the firm͛s earnings after
deducting the amount of dividends paid. As the dividends for the period appear twice on the RHS of the
equation with opposite signs, they sum to zero and hence eliminated.

  5  6 6-&+O &+' & ,,7        (5.1)

Where  is the value of the firm at time ;  stands for present value;  is the total dividends paid
during period ; O is investment; and ' is the firm͛s net profit for period .

The firm͛s value at the ending of the period can correspondingly be defined as the dividend paid during
that period plus the value at that period end less external finance raised throughout the period, and so
forth for all future periods. The present value of the firm can as a result be expressed as the inestimable
sum of the present values of future earnings less investment expenditures. In view of the fact that
profits, investment and the discount rate are all independent of dividend either by their nature or by
assumption, the conclusion is that the dividend decisions has no effect on value.

When the suppositions underling the irrelevancy theory are unperturbed the question is whether it is
still reasonable to conclude that dividends will have no effect on expected earnings, investment or on
the firm͛s risk and hence the discount rate. For instance, future earnings of a firm that pays dividends
may be lower relative to a similar firm that does not pay dividends comprises incurring transaction costs
or extra taxes. Indeed, much of the dividend literature has focused on the entailments of relaxing the
Miller & Modigliani (1961) irrelevancy theory assumptions and of introducing market imperfections.

The text that deals with dividend policy in the presence of market imperfectnesses may be categorized
under two basic views: for and against. On the ͚against͛ camp are theories comprising the transaction
cost theory of dividend and the tax hypothesis that suggest that dividend payments reduce shareholder
wealth. On the ͚for͛ cam are theories that suggest that dividend payments increase shareholders wealth,
comprising the bird in hand argument, the signaling theory and the agency theory of dividend. All these
theories have been broadly discussed and tested but to date there is no agreement on how firms
determine their dividend policies.

9"#""ã

 
 
   


Firms may gain costs in distributing dividends while investors may incur costs in collecting and
reinvesting these payments. In addition, both firms and investors may deserve costs when, due to
paying dividends, the firm has to raise external finance in order to meet investment needs. Certainly, the
transaction costs obtained in having to resort to external financing, is the cost of dividend in

investors are certain about the future investment and profits of all firms, thus there is no need to distinguish
between debt and equity and an all equity firm is assumed.
rhattacharya͛s (1979) model. In contrast, nevertheless, it may be argued that dividend are beneficial as
they save the transactions costs associated with selling stocks for consumption purposes. Either way, if
there are additional transaction costs that are related with paying or not paying dividends, then
dividend policy should impact earnings expectations and consequently share price and firm value.

Alternatively dividends may influence value if dividend policy has an influence on management͛s
investment decisions. For instance, managers may decided to forgo positive net present value
investments for the reason that dividend payments exhausted internal finance and raising external
funds comprises transaction or other costs. Indeed in Miller and Rock͛s (1985) model the cost of
dividends arise from cutting or distorting the investment decision. Nevertheless, more characteristically,
the transaction cost theory of dividend retains the assumption of a given level of investment, and
focuses on the costs of raising external funds when the firm increases its dividend payment. Transaction
costs comprise flotation costs to the firm of raising additional external finance such as underwriter fees,
administration costs, management time, and legal expenses. Further, when the firm pays dividend and
then has to raise additional external finance, existing shareholders suffer dilution of control. Accordingly
to maintain control or for other reasons, existing shareholders may subscribe to the new issue, incurring
trading costs such as stamp duty and stockholders͛ commissions. Finally all these transaction costs are
reflected in the share price and firm value.

In addition to explicit transaction costs there are also less noticeable costs that are related with paying
dividend and resorting to external finance, and which are due to information asymmetries and pecking
order considerations. Chiefly, raising new equity can be costly if it comes at a time when the shares are
temporarily under-valued or due to the signals this action send to the market regarding the value of the
firm. In the same way, debt issues are also problematic for the reason that the announcement of the
issue may be related with increased probability of default and with managers trying to issue debt before
such bad news are revealed. Like explicit transaction costs, these less obvious costs should also
influence earnings expectations and be reflected in the firm͛s share price and value.

Consequently, due to the costs connected with raising external finance, the transaction cost theory of
dividend suggests that firms should make use of retained earnings to the extent possible. Dividend
should only be paid when this does not result in shortage of internal funds that are essential for
investment. Thus Rozeff (1982) suggests that firms that have larger reliance on external finance would
maximize shareholder wealth by adopting lower payout policies. Leverage, growth potential and
instability are all factors that can increase dependency on costly external funds. High levels of leverage
imply high fixed costs that the firm has to ensure it can meet. Growth potential means the firm is faced
with good investment opportunities for which it require funds. Likewise earnings volatility suggests that
dependency on external finance is higher for the reason that there is less certainty concerning earnings
to be generated. This entails that highly leveraged, risky or growth firms should be related with
traditional payout policies.

Another significant factor that has entailments for control consideration and for the transaction costs of
raising external finance and thus for firms͛ dividend policies, is size. Particularly, the ownership structure
of small companies is likely to be less dispersed than that of larger firms. The more dispersed is
ownership the less control is exercised by each shareholder and hence the problem of loosing control is
more serious for smaller firms. Further, the cost of external finance is likely to be privileged for smaller
firms compared with larger, well-established firms with easier access to the capital markets. Ass to this
the observation that growth firms are generally smaller and the conclusion is that small firms are likely
to find the payment of dividends more costly compared with larger firms. This conclusion may explain
the positive correlation often observed between firm size and the likelihood that the firm is a dividend.

   

Another cost linked with dividend payments is taxes. The tax hypothesis proposes that corporate tax on
distributions and taxes on dividends in the hand of investors are significant costs to be well thought-out
when deciding on a dividend policy. More specifically, the difference between tax on dividends and on
capital gains should be considered as well as the distinction between corporate tax on distributed and
on retained earnings. For instance, if corporate tax on distributions is higher than that on retained
earnings, this may reduce expected earnings of a firm that pays dividends relative to a firm that does
not. In the same way, if dividends in the hands of shareholders are taxed higher than capital gains,
investors should evaluate expected returns on an after tax basis and share prices will vary inversely with
the firm͛s payout level. Undeniably, the basic tax hypothesis proposes that additional taxes on dividends
make capital gains a less costly way of returning wealth to shareholders. Thus, the basic tax hypothesis
supports a conservative dividend policy, and proposes that if the firm wants to return cash to
shareholders then this should be done through share purchases. It is thus puzzling to find that even
though repurchases have increased since the 1980s, they have not substituted for dividends.

Nevertheless, Miller and Scholes (1978) show that under two provisions of the US Internal Revenue
Code, taxable investors may still be indifferent to dividends even when the tax regime favours capital
gains5. In addition, Miller and Modigliani (1961) argue that despite the presence of taxes, tax-induced
clientele effect greatly reduces the tax costs of dividends. The idea is that there may be clienteles for
both high and low dividend yields depending on tax positions. Institutions, which are often tax-exempt
and individuals at low tax brackets may prefer companies with high payout policies. Other investors at
high tax brackets for whom the relative tax cost of dividends is considerable will prefer firms with low
payout policies. Shareholders select firms whose policies suit their preferences. As there are enough
firms to satisfy all, no firm can increase its value by changing its dividend policy. In addition, by changing
its dividend policy, a firm may trigger a change in clientele and this could be costly due to trading costs.
Therefore, the clientele effect hypothesis supports the dividend irrelevancy conclusions.

 r   # ¢

 

5
The first provision used to illustrate the irrelevancy of taxes in Miller and Scholes (1978) is the ability to deduct
interest payments from investment income received, in calculating tax liability. The second provision is that
insurance companies pay no taxes on investment income. Thus, if the firm increases its dividend, a taxable investor
can avoid the additional tax liability by increasing his interest liability to the point where it matches the increased
level of dividends. To maintain the same level of risk, the investor can use the proceeds from the additional
borrowings to buy insurance policy. This increases the investor͛s level of assets so that his debt ratio is unchanged.
The conventional argument in favour of dividend is the idea that dividends reduce risk for the reason
that they bring shareholders͛ cash inflows forward. Although shareholders can create their own
dividends by selling part of their holdings, this entails trading costs, which are saved when the firm pays
dividends. The risk reduction or bird in the hand argument is connected with Graham and Dodd (1951)
and with Gordon (1959) and it is often defended as follows. ry paying dividends the firm brings forward
cash inflows to shareholders, thus reducing the vagueness related with future cash flows. In terms of the
discounted dividend equation of firm value, the idea is that the required rate of return demanded by
investors (the discount rate) increases with the plough-back ratio. Even though the increased earnings
retention brings higher expected future dividend, this additional dividend stream is more than offset by
the increase in the discount rate.

This argument neglects the fact that the risk of the firm is decided by its investment decisions and not by
how these are financed. The mandatory rate of return is influenced by the risk of the investments and
should not change if these are financed from retained earnings rather than from the proceeds of new
equity issues. As distinguished by Easterbrook (1984), despite of paying dividends the firm does not
withdraw from risky investments, thus the risk is merely transferred to new investors.

 


 

A more persuasive argument in favor of dividends is the signaling hypothesis, which is linked with
propositions put forward in rhattacharya (1979), Miller and Rock (1985), John and Williams (1985), and
others. It is based on the idea of information asymmetries between the various participants in the
market and in particular between managers and investors. Under such circumstances, the costly
payment of dividend is used by managers, to signal information about the firm͛s prospects to the
market. For instance, in John and Williams͛ (1985) model the firm may be temporarily under-valued
when investors have to meet their liquidity requirements. If investors sell their holdings when the firm is
undervalued, then there is a wealth transfer from old to new shareholders. Nevertheless, the firm can
save losses to existing shareholders by paying dividends. Even though investors pay taxes on the
dividends, the benefits from holding on to the undervalued firm more than offset these extra tax costs.
A poor quality firm would not mimic the dividend behaviour of an undervalued firm for the reason that
holding-on to over-valued shares does not enlarge wealth.

The signaling hypothesis can give details about the preference for dividends over stock repurchases in
spite of the tax benefit of the latter. Predominantly, as suggested in Jagannathan, Stephens and
Weisbach (2000) among others, the regular dividend signal an ongoing commitment to pay out cash.
This signal is dependable with Lintner (1956) observation that managers are characteristically reluctant
to decrease dividend levels. Nevertheless, unlike regular dividends, repurchases and special dividends
can be used to signal prospects without long-term commitment to higher payouts. For that reason,
announcements of increases in regular dividends signal permanent improvements in performance, and
should be interpreted as confidence in the firm on behalf of managers thus triggering a price rise. On the
other hand, announcements of dividend decreases should be interpreted as signaling poor performance
and lack of managerial confidence and should for that reason trigger drops in prices.
If changes in the levels of dividend release information to the market, then firms can decrease price
volatility and manipulate share prices by paying dividends. Nevertheless, it is only unexpected changes
which have an informative value and which can thus impact prices. Therefore, the value of the signal
depends on the level of information asymmetries in the market. For instance, in developing countries
where capital markets are typically less competent and where information is not as reliable as in more
sophisticated markets, the signaling function of dividend may be more significant. Furthermore, it can
be argued that information will finally be revealed whether or not the dividend signal is sent, therefore
the dividend affect on prices is only temporary.

 ¢
     i
 

One more argument in favour of generous dividend payments is that this shifts the reinvestment
decision back to the owners. The primary assumption is that managers may not essentially always act as
to maximize shareholders͛ wealth. The problem here is the separation of ownership and control which
gives rise to agency conflicts as defined in Jensen and Meckling (1976). Therefore when the levels of
retained earnings are high managers are expected to channel funds into bad projects either in order to
advance their own interests or due to incompetency. Therefore, generous dividend policy raises the
firm͛s value for the reason that it can be used to decrease the amount of free cash flows in the
discretion of management and thus controls the over investment problem.

Another agency theory based explanation of how dividends augment value is described in Easterbrook
(1984). While the transaction cost theory of dividend proposes that dividend payments reduce value for
the reason that they lead to the raising of costly external finance, Easterbrook (1984) argues that it is
this process which reduces agency problems. The idea is that the payment of dividends is one possible
solution to the problem of collective action that tends to lead to under-monitoring of the firm and its
management. Hence, the payment of dividends and the subsequent raising of external finance induce
investigation of the firm by financial intermediaries such as investment banks, regulators of the
securities exchange where the firm͛s stock is traded, and potential investors. This capital market
monitoring cuts down agency costs and lead to appreciation in the market value of the firm.
Furthermore, total agency cost, as defined by Jensen and Meckling (1976), is the sum of the agency cost
of equity and the agency cost of debt. The later is partly due to potential wealth transfer from bond to
equity holders through assets transpositions. Thus Easterbrook (1984) note that by paying out dividends
and then raising debt, new debt contracts can be managed to decrease the potential for wealth transfer.


'ã"


ã
 

The dividend theories discussed in the preceding section speak about the affect of dividend on value of
transaction costs, taxes, risk, signaling and agency conflicts. Nevertheless, the chief empirical studies of
the dividend policy puzzle focus in particular on the tax hypothesis, the signaling hypothesis and agency
studies6.

6
Indeed these three theories (agency, asymmetric information and taxation) also commonly underline empirical
work of the other financing decision, namely the capital structure choice.
Therefore, following the spirit in Prasad, Green and Murinde (2001), it is around these three theories
that the following debate is organised. Transaction costs that are incurred due to changes in dividend
policies are usually incorporated into each of these main hypotheses. These costs are usually assumed
to be a function of reliance on external finance and are controlled for by variables such as growth, size
or profit. Relatively little empirical work has been conducted on the bird in hand argument consequently
this branch of empirical work is discussed no further7.

Testing approaches depend to a large extent on the hypothesis under investigation. The clientele effect
is often evaluated by an event study around the dividend payment days. Other tax studies look at the
trading activity rather than the stock price behaviour around ex-dividend days. Some tax hypothesis
studies take an another approach, and review the affect impact of tax reforms on relative prices while
other regress the dividend policy on tax proxies to assess the significance of the latter in influencing the
former.

Studies that investigate the signaling hypothesis often follow an event study around the dividend
announcement period. Other signaling studies assess revisions in earnings forecasts following
unexpected changes in dividends. A different approach to testing the validity of the signaling hypothesis
is by looking at changes in firm characteristics, following changes in its dividend policy. A particular
attention has often been paid to changes in earnings. Cross sectional comparisons between firms of
varied characteristics are also used to assess how such distinctions may influence the value of the
dividend signal.

Agency theory studies usually use regression analysis to evaluate the degree of substitutability among
alternative mechanisms for controlling agency problems. Another approach, which is characteristically
classified under the agency theory umbrella, is testing the fittingness of Rozeff͛s (1982) cost
minimization model. The cost minimization model actually combines transaction costs theory with
agency theory, and proposes that the optimal payout ratio is that which minimizes the sum of costs of
paying dividends. Thus, Rozeff (1982) and subsequent studies regress a proxy of the optimal payout
ratio on proxies for agency costs that may be controlled by paying dividends and on proxies for
transaction costs that are associated with dividend payment.

The literature review of this section will proceed by investigating a limited number of studies dealing
with each of the above discusses theories in turn. Nevertheless, some researchers have attempted to
model the management͛s decision-making process that determines dividend changes. Some of these
behavioral models, notably Lintner͛s (1956), have significant implications in particular for the signaling
theory and are therefore described first.

r 

  E *

¢&   

7
One exception is Allen and Rachim (1996) who investigated the relation between risk and the dividend policy
using 173 Australian listed companies for the period 1972 to 1985. Stock price volatility is regressed on the
dividend yield and on six control variables including earnings volatility, payout ratio, debt, growth, size and
industry dummies. The study fails to find evidence that dividend yield is significantly correlated with stock price
volatility, which suggests rejection of the bird in the hand (or duration) effect.
   


One approach to dealing the dividend puzzle is to comprehend the management͛s decision-making
process that determines dividend changes. Undeniably, this is the approach in Lintner (1956), who carry
out a series of interviews with the managers of 28 US industrial firms about their firms͛ dividend policies
in the 7 years from 1947 to 1953. From the survey it comes forth that firms tend to establish dividend
policies with target payout ratios that are applied to current earnings. It is also found that firms have
adjustment rates that establish the percentage of the largest change by which dividend levels are
actually changed. Lintner (1956) also reports that although the target payout ratios and speed of
adjustments vary across firms, in most cases they stay sensibly stable over time.

Established on his findings, Lintner (1956) develops the partial adjustment model of the change in the
dividend level from the previous to the current period. The model reflects management͛s belief that
investors dislike erratic patterns in dividend levels and hence the emphasis is one the change from the
previous actual level:

 8 596 : ;+ &-,76
  (5.2)

Where,

8 5 &+ -, (5.3)

: 5á+ ,          (5.4)

Thus, 8 is the change in the dividend payment;  and + -, are the amounts of dividends paid in
years and &- respectively; :  is the target divided amount where á is the target payout ratio and 
is current profits after tax;  is the speed of adjustment; 9 is a constant which in general will be positive
to reflect management͛s reluctance to reduce dividends;
 is an error term. Equation (5.2) can
alternatively be expressed as follows:

 59 6  6(+ -,6
 (5.5)

Where

5+á, and (5-&

As per Lintner (1956), current net earnings, Pt, play the most significant role in determining dividend
changes. This is for the reason that current earnings are widely available and hence managers͛ view is
that investors expect dividends to reflect changes in this variable. Expanding (5.5), noting that + -, can
be expressed as a function of that period͛s profits and the previous period͛s dividends, the dividend
pattern is a smoothed pattern of earnings and is indicative of the time path of permanent earnings. The
degree of smoothing depends on the speed of adjustment coefficient, .

Therefore, the three key factors in the partial adjustment model are the speed of adjustment
coefficient, , the target payout ratio, á, and current earnings,  . Undeniably, the three questions that
are usually raised about the Lintner model concern these factors. First, some researches have examined
what decides the speed of adjustment and hence the degree to which smoothing takes place. Second,
some researches try to establish whether firms have long-term target payout ratios towards which they
move. Third, the question of whether current earnings are the key determinant of dividends has been
investigated. In general, nevertheless, empirical tests of the Lintner model have confirmed its validity.
One of the earliest and widely quoted such study is by Fama and rabiak (1968). One more, which is
going to be reviewed here for the reason explained below, is by Mookerjee (1992).

Mookerjee (1992) is unique in that it applies the Lintner model, which has been developed on the basis
of a US survey, to a developing rather than a developed country. Chiefly, annual data for the aggregate
Indian corporate sector for the period 1949 to 1981, before important reforms were introduced, is
utilized to show that the basic Lintner model performs well in explaining dividend behaviour in India.
Alteration of the basic model, by adding the availability of external finance as an explanatory variable,
improves the fit of the model. Indeed, the lagged external finance enters with an important and positive
estimated coefficient reflecting access to subsidized borrowing and hence tendency to use borrowing to
finance higher dividends. Mookerjee (1992) also notes that the constant in the Lintner model is
hypothesized to be important and positive, reflecting the fact that firms are more willing to raise rather
than lower dividends. Even though the study finds the constant to be important under all specifications,
it enters with a negative sign in all regressions. It is suggested that this could be reflection of the affect
of taxes8.

Even if the study by Mookerjee (1992) is supportive of the Lintner͛s model, it also addresses the third of
the three questions discussed above, that are often raised with reference to this model. Specifically this
is the question of whether management set the desired dividend level as a fraction of current earnings
or as a fraction of permanent earnings. If the latter is the case and it is assumed that earnings follow a
random walk with a drift, than the lagged profit after tax, should enter with a negative and important
coefficient. Mookerjee (1992) finds that although the lagged earnings enter with a negative coefficient,
in all cases it is also unimportant. In contrast, Lee (1996) finds stronger support for the view that it is
permanent earnings as oppose to current earnings that determine dividend.
The study by Lee (1996) assesses whether there is long-term relationship between different definitions
of earnings and dividends. The study utilises a bivariate time-series model of earnings and dividend
obtained from annual observations on the Standard & Poor's Index for the period 1871 to 1992. The
model is adequately universal to allow various specification of target dividend to be nested within it.
These restrictions are then tested, taking into account the non-stationarity of the dividend and earnings
series and the cointegration between them. The results show that dividend behaviour is determined
primarily by changes in permanent earnings and that the Lintner model performs better when the target
payout ratio is a function of permanent rather than current earnings. This is supportive of the signalling
hypothesis in the sense that current earnings are not a good pointer of the long-term financial position,
therefore managers utilise dividends to signal this position.
Shirvani and Wilbratte (1997) also use cointegration (albeit multivariate rather than bivariate)
techniques to test the validity of the Lintner model. Nevertheless, their main aim is to address the
second of the three questions mentioned above, namely whether firms have long-term payout ratios.
Using quarterly observations on the Standard & Poor͛s 500 index for the period 1948 to 1994, the first
stage is to confirm the nonstationarity of the dividends, earnings and price index series. In addition, as

8
Mookerjee (1992) note that traditionally income tax had been very high in India, disadvantaging dividend
payments over capital gains. It is also noted, however, that this trend began to reverse in the mid-1970s.
these three series are found to cointegrate, tests of the coefficients in the cointegrated equation point
to a long-run relationship between earnings and dividends. In general the hypothesis that the
coefficients on the logs of the dividend and earnings variables, are equal and of the opposite signs is not
rejected.
The Shirvani and Wilbratte's (1997) study further counts on the error correction model to capture short-
run deviations from the long-run target payout ratio and the speed of adjustment. Thus the study also
touches on the first of the three questions about the Lintner model, specifically the question of what
determines the speed of adjustment. It is found that firms apply varied adjustment rates in raising and
lowering dividends. When the payout ratio is below its long-run target, the firm will increase dividends.
Nevertheless, when the payout ratio is above its target, the firm will hold the dividend level constant
and wait for earnings to grow so that the target payout ratio is achieved. This ratchet effect is
interpreted in terms of the signalling theory, and in particular as a way of avoiding the bad signals
connected with dividend reductions.
The idea that the speed of adjustment is determined by the signalling role of dividends is also supported
in Dewenter and Warther (1998). The study reports the results from running the partial adjustment
model for each of 180 Japanese firms and 313 US firms with at least five years of nonzero dividend
during the period 1982 to 1993. It is found that the median speed of adjustment is higher for Japanese
firms compared with US firms, and higher still for Keiretsu members. This pattern is explicated by the
observation that the Japanese business environment is characterized by less information problems, thus
there is less need for the dividend-smoothing device in the case of these firms.
Turning back to the question about the existence of long-term payout ratios, Hines (1996) looks at
possible reasons for the Lintner (1956) observation that payout ratios vary across firms. In particular, the
payout rates of 505 US firms for the period 1984 to 1989 as well as the dividend patterns for the
aggregate US corporate sector during the period 1950 to 1986 are investigated. Hines (1996) finds that
the payout rates applied to profits from foreign sources are about three times higher than the payout
rates applied to domestic profits. These findings support the signalling hypothesis in view of the fact
that information asymmetries surrounding overseas operations are likely to be more acute than for
domestic activities. Managers, thus, may feel a stronger need to send signals regarding the prospects of
foreign operations.
 

   

    
¢ 
 


Table 5.1 summarizes the pertinent key issues of each of the empirical studies reviewed in this section.
Empirical findings appear to support the validity of the partial adjustment model, not only in respect to
the behaviour of US firms, as shown in Fama and rabiak (1968), but also with respect to the behaviour
in less developed countries as in Mookerjee (1992). The other studies reviewed above address the three
questions that are related with the Lintner model regarding the existence of a target payout ratio, the
determinants of the speed of adjustment coefficient, and the degree to which current earnings make
clear dividend levels.
The Lintner͛s idea of a long-term payout ratio is supported in Shirvani and Wilbratte (1997), while Hines
(1996) provides evidence supporting the notion that difference in the payout target is due to the
signalling role of dividends and the degree of information asymmetries faced by the firm. The signalling
role of dividends is likewise supported by Shirvani and Wilbratte (1997), who show that firms apply
different adjustment rates to dividend increases and decreases. In addition evidence on what
determines the speed of adjustment towards target dividend is given in Dewenter and Warther (1998).
Finally, Lee (1996) shows that the partial adjustment model works better when the target dividend is
modelled as a function of permanent as opposed to transitory earnings.
$10ã





 *

¢&
  
ã ¢
  (   



) 



Lintner (1956) To assess the process by 
which dividends are US, 28 industrial firms
determined through selected to ensure a
interviews with wide range of
managers of US firms circumstances under
which managers
operate, 1947-1953
! Firms are primarily
concerned with the
stability of
dividends. Managers
prefer a gradual
upward trend in
dividends.
  ! Earnings are the
! Survey ʹ interviews most significant
with managers to determinants of any
learn of the dividend change in dividends
policy of their firms ! Dividend policy is set
over the previous first and other
seven years policies are then
! Constructing a adjusted
model that describes ! The market reacts
the dividend change positively to
behavior dividend increase
! Testing the model in announcements and
predicting post-war negativity to
dividend of all announcements of
American dividend decreases
corporations

Change in dividend M ɲ+
(speed of adjustment
coefficient) (target
dividend ʹ actual lagged
dividend)
Where target dividend
is the target payout
ratio applied to the
current year͛s profits
after taxes.

Fama and rabiak (1968) Testing the Lintner  ! Net income appears
dividend model US, 392 major industrial to explain the
firms over the period dividend change
1946 to 1964 decision better than
  a cash flow measure
1. Ordinary Least ! The Lintner model
Squares time series performs well
of a number of relative to other
specifications of the models.
Lintner model for Nevertheless,
individual firms, deleting the
assessing the constant and adding
statistical
 characteristics of the the lagged earnings
distribution of the variable leads to a
estimated slight improvement
coefficients (using in the predictive
part of the sample to power of the model.
estimate the models
and the other part to
validate it)
2. Monte Carlo
experiments ʹ
generating series for
earnings, dividends
and the error terms
based on
assumptions
regarding the data
generating process.
Then using artificial
samples to estimate
the coefficients. The
estimated
coefficients are
compared with the
coefficients of the
model actually used
to generate the
data.

The Lintner model

Mookerjee (1992) Apply the Lintner partial  ! The basic Lintner
adjustment model and Annual data for the model is good in
modifications of this aggregate Indian explaining the
model, to a developing corporate sector, 1950- dividend behaviour
country, India 1981 (all variables in India. All variables
expressed in real are significant at
termed by deflating by conventional levels
the consumer price and the model
index). explains 61% of
  variation
Ordinary Least Squares ! Adding external
 finance in previous
8+ 
,59269- period as
+
 

 !,&91 explanatory variable
+ 

 

 !, improves the model.
&9'+ 
 
, This is explained by
690+ 

!

 access to subsidized
 
, borrowing which
   encourage firms to
! ѐ(dividend) M ʹ0.33 + use borrowings to
0.62 (Profit after tax) ʹ finance dividends.
0.73 (Lagged dividend) ! The constant is
! ѐ(dividend) M ʹ1.04 + significant but enter
0.28 (profit after tax) ʹ with a negative sign,
0.79 (Lagged dividend) reflecting dividend
+ 0.37 (Lagged tax disadvantage in
external finance) India.
! ѐ(dividend) M ʹ0.99 +
0.32 (Profit after tax) ʹ
0.09 (Lagged profit
after tax) ʹ 0.72
(Lagged dividend) +
0.36 (Lagged external
finance)
Lee (1966) Test the hypothesis that  ! Changes in dividends
dividend changes are US, annually, are influenced by
determined by changes aggregated (real) data permanent earnings,
in permanent earnings. on the S&P Composite but not by transitory
Show that the Lintner Index, 1871-1992 earnings, but not by
model performs better   transitory earnings.
when the target ! Testing for Therefore, the
dividend is a function of cointegration spread between
permanent as opposed between various dividends and
to current earnings. definitions of earnings is
earnings and influenced by
dividends. transitory earnings
! Constructing a but not by
rivariate Vector permanent earnings.
Autoregression ! The hypothesis that
(rVAR) of change in the target dividend
dividends and the in the partial
spread between adjustment model is
earnings, and a function of
dividends. permanent earnings
! Testing nested is not rejected while
models in the rVAR the hypothesis that
to assess whether the target dividend
permanent earnings, is a function of
transitory earnings current earnings is
or current earnings, rejected.
influence dividends.

! Permanent earnings
hypothesis: Change
 in dividend M ɲ1
(change in the
permanent
component of
earnings)
! Partial adjustment
model: Change in
dividend M (speed of
adjustment) ×
(target dividend ʹ
lagged dividend)
  
! Earnings and
dividends are non-
stationary but are
cointegrated.
! Hence, the rivariate
Moving Average
Representation of
the first difference in
dividends and the
spread between
earnings and
dividends in
invertible and can be
specified as a rVAR.
Shivani and Wilbrate Use cointegration  ! Current earnings is
(1997) analysis to check for US, quarterly, the strongest proxy
existence of a long-term aggregated (real terms) for ability to pay
stable payout ratio. Use data on the S&P500, dividends.
the error correction 1948:1 to 1994:4 ! The cointegration
equations to assess the   results suggest that
ratchet effect. Multivariate firms pursue a long
cointegration tests run payout ratio,
 consistent with the
Long-run model: Error Lintner model.
term M ɽ1 log of ! Short run ratcher
dividend ʹ ɽ2 log of effect ʹ firms apply
earnings + ɽ3 log of different adjustment
price level + ɽ4 methods to raising
   and lowering payout
Long-run model: Error ratios. This is due to
term M log of dividend ʹ signaling effects.
1.045 log of earnings +
0.097 log of price level +
0.185 LR test of H0:ɽ1 +
ɽ2 M ɽ3 M 0; 0: x21 M 0.75
with probability value
 of 0.30.

Dewenter and Warther Compare the  ! The dividends of

(1998) responsiveness of the 313 US firms and 180 Japanese Keirestu
dividends of US and Japanese companies firms are mor
Japanese firms to with at least 5 years of responsive to
earnings changes nonzero dividend and earnings changes
earnings data. 1982- than those of both
1993 US firms and
 
Run the Lintner model
without the intercept ! Thus US dividends
term for each firm and
obtain the medium
speed of adjustment
coefficient for the
samples of US firms and
Japanese firms. Also
split the Japanese
sample as per Keiretsu
membership and
compare the median
speed of adjustment
across these sub-
samples.
Japanese
independent firms.
are smoother than
Japanese dividends
and this is due to the
observation that
Japanese firms and
keiretsu firms in
particular, face less
information
asymmetry and
fewer agency
conflicts than US
firms.

Lintner model without
the constant



The median speed of
adjustment estimates
are 0.055 for all US
firms, 0.094 for all
Japanese firms, and
0.117, 0.082, and 0.021
for keiretsu, hybrid, and
independent firms,
respectively.
Hines (1996) Look at possible  ! Different payout
determinants of payout US, 505 firms for the ratios are applied to
rates by exploring the period 1984-1989 and domestic and
connection between aggregate US data foreign profits ʹ US
payout ratios and the covering the time corporations pay
share of firms͛ profits period 1950 to 1986 dividends out of
from overseas sources.   their foreign profits
! Ordinary least at about three times
squares regression the rate that they do
using cross sectional out of their domestic
 firm-level data for profits
each of the years ! This may be due to
1984 to 1989 the signaling
! Ordinary least function of dividends
squares regression if foreign profits are
using time series on particularly difficult
aggregate data for investors to
 verify.
Dividend payout M [after
tax domestic profits +
ɻ(after tax foreign
profits)] ɲ



Firm-level for year
1986: Dividend payout
M 0.2353 after tax
domestic profits +
0.7290 after tax foreign
profits

refore proceeding to the next section, it is significant to note that other behavioural model to that of
Lintner (1956) have been suggested and tested. For instance, Cyert, Kang and Kumar (1996) develop a
behavioural model where firms do not have a target long-term payout ratio for the reason that
managers do not like predicting long term future events. Instead, the model is based on the notion that
managers seek to avoid uncertainty and to optimise self welfare.
Nevertheless, whether managers have long-term target payout ratios or whether they follow shorter-
term goals, the behavioural models imply that managers͛ intentions and information on the firm and its
future can be inferred from the dividend decision. This is the notion underlying the signalling hypothesis,
the empirical evidence on which is reviewed immediately after the following review of selected
empirical studies of the tax hypothesis of dividends.



      

!

 
The basic tax hypothesis suggests that for the reason that personal taxes on dividends tend to exceed
those on capital gains, firms have an incentive to adopt a conservative payout policy and such policy
should be value enhancing. A probable method to evaluate the validity of this hypothesis is to study
stock price and dividend policy changes in respond to tax reforms. Hubbard and Michaely (1997) and
Papaioannou and Savarese (1994) adopt this methodology. Alternatively the significance of taxes to the
dividend decision may be assessed by regressing dividend policy on proxies for the tax cost of dividends.
Gentry (1994) and Lasfer (1996) adopt this methodology. Using data on firms that are listed on either
the NYSE or the AMEX for 1987 (65 firms) and 1988 (64 firms), Gentry (1994) finds support for the tax
hypothesis. The study investigates the dividend policies of corporations versus Publicly Traded
Partnerships (PTPs) in the oil and gas exploration industry. PTPs and corporations in the oil and gas
industry are of similar size and this makes them comparable. The chief distinction between PTPs and
corporations is that during the period studied PTPs were not taxed at the corporate level and hence
escaped the US double taxation system. For that reason, if the tax hypothesis is valid, as PTPs have
lower tax cost associated with the payment of dividends, their payout rates should be larger. Using cross
sectional instrumental variable technique, the dividend payout is regressed on an organisational form
dummy as well as on a number of other control variables. Results of the study point to that firms
consider taxes when formulating their dividend policies and that, coherent with the tax hypothesis, PTP
pay more dividends than corporations.
In addition support for the tax hypothesis, is provided by Lasfer (1996) who uses 108 firms quoted on
the LSE for the period 1973 to 1983. The study regards both personal and corporate taxes by running a
regression of the partial adjustment model. The original partial adjustment model is adapted to
integrate the effects of both personal and corporate taxes on the determination of the long run target
dividend level. Lasfer (1996) tests whether the target dividend (and therefore also the actual dividend) is
a function of earnings, of a tax discrimination variable and of a tax exhaustion dummy. The tax
unfairness variable, surrogating for the effects of personal taxes, varies inversely with the personal
income tax rate. When the tax discrimination is better than one, income tax on dividends is cheaper
than tax on capital gain and the firm is anticipated to prefer a high payout policy. The tax exhaustion
dummy, surrounding for the effects of the firm͛s tax position, is set to one if the taxable profit is lower
than gross dividends and advanced corporation tax (ACT) is irrecoverable. When ACT is disregarded, the
firm is anticipated to prefer a low dividend payout, and consequently the coefficient is expected to be
negatively signed.
Results in Lasfer (1996) show all variables to be important and to enter with the signs predicted by the
tax hypothesis. In addition, results of an event study are also supportive of the tax hypothesis, rejecting
the tax induced clientele effect. Particularly, important and positive abnormal returns are reported on
the ex dividend day frequent running with the notion that the price drop on the ex dividend day is
systematically less than the value of the dividends. The basic behind this is dividend taxation, which
causes the value of the dividends to investors to be less than their nominal amount. The study concludes
that taxes affects both the dividend policy and exdividend day returns, and that firms set their dividend
policies so as to maximize the after tax returns to their shareholders as well as to minimize their own tax
liabilities.
Similarly Lasfer (1996), Papaioannou and Savarese (1994) also utilize an elaborated dividend partial
adjustment model on a sample of 236 industrial and 40 utility US firms for the period 1983 to 1991.
Nevertheless, they focus on firms͛ reaction to the US Tax Reform Act of 1986 (TRA). Undeniably the
study provides influence that firms adjust their dividend policies in response to changes in the tax
system and this is interpreted as supportive of the tax hypothesis. It is reported that a total of 23.2% of
the sample firms experience shifts important at the 10 percent level in their target payout ratios in the
post-TRA period. This provides further support for the notion that firms consider taxes when setting
their dividend policies.
The Tax Reform Act, 1986 is also utilized by Hubbard and Michaely (1997) to evaluate the affects of
taxes on dividend policy. Specifically, it is studied whether shifts in tax policies have led to shifts in the
comparative values of two classes of common shares of a single firm, the Citizen Utilities Company (CU).
It is noted that during the period studied holders of class A stock received stock-dividends while holders
of class r stock received cash-dividends. The relative price of the shares should for that reason reflect
preference or aversion to cash dividends. In addition, the TRA reduced the relative aversion of investors
paying tax on dividends at the personal income tax rate to dividend. Therefore if taxes are significant
than the relative value of class r should have increase after 1987.
Hubbard and Michaely (1997) begin by obtaining the dividend-adjusted average relative price of CU for
each of the periods 1982-1984 (pre-TRA), 1985-1986 (TRA implementation period) and 1987-1989 (post-
TRA). The relative price is calculated as the ratio of the average price of class A to the average price of
class r divided by the relevant dividend ratio. It is found that although the relative price declined
significantly from 1.01 in the pre-TRA period to 0.91 in the accomplishment period, this relative increase
in the value of class r shares did not have a lasting impact. The relative price in the post-TRA increased
to its pre-TRA level. Further, over the period 1978 to 1993 the relative price is found to be around unity.
This is in spite of the tax shortcoming of cash dividends during that period, and is therefore incompatible
with the tax hypothesis.
Probable explanations for the discrepancy between the tax hypothesis and the observed price behaviour
of the two classes of CU͛s shares are explored in Hubbard and Michaely (1997). One suggested
explanation is that clientele influences may be the reason that value is not affected by the tax changes.
Undeniably it is noted that clientele effects could also explain the temporary change in value during the
TRA implementation period in terms of shifts in clientele. Even though Hubbard and Michaely (1997) do
not find evidence in support of clientele effect, other empirical studies do.
!




 
The tax clientele effect speaks about the preference of different categories of investors, on the basis of
their tax position, for various types of stock. Accordingly firms adjust their dividend policies and
investors move to satisfy their tax requirements, until, in equilibrium, no value can be added by
changing dividend policy. One probable method of establishing whether a tax-induced clientele exists is
to investigate the relationship between the dividend yield on stocks and the marginal income tax rate of
investors. Specifically, the finding of an inverse relation between dividend yield and marginal tax rates is
supportive of the presence of a clientele effect. Elton and Gruber (1970) suggest that clienteles͛
marginal tax rates can be inferred from the ex-dividend day price behaviour. This point, for the case of
preferential tax treatment for capital gains, is explained in Green and Rydqvist (1999) as follows.
If stocks offer no ex-dividend-day compensations then investors will be unwilling to sell ex-dividend.
Selling on ex-dividend days implies paying higher taxes on the dividends and this can be avoided by
selling cum-dividend. On the cum-dividend day the price comprises the present value of the dividends to
be paid but this is taxed at the (lower) capital gains rate. To ensure investors are willing to hold stock
through the payment day and sell ex-dividend, the after tax receipts to the seller who trade on the cum-
dividend day must, in equilibrium, be equal to the after tax receipts to the seller who trade on the ex-
dividend day. This equilibrium position is shown in Elton and Gruber (1970) to be:
% &%'(% )%*+i&,- '     <
Where  is the cum-dividend day stock price; Po is the price for which the stock was purchased; 
is the
ex-dividend day price;  is the amount of dividend; and  and  are the personal tax rates on capital
gains and dividends respectively.
An expression for the ex-dividend day price drop is obtained from Equation (2.6) and is shown to reflect
the marginal tax rate on dividend relative to capital gains of the clientele holding that stock:
&%'.i(&,- '.&,- '      (5.7)
If tax clientele exists than the ratio of the drop in price relative to the nominal dividend amount should
be closer to unity for high-yield stock and less than harmony for low-yield stock. This is for the reason
that high-yield stock is held by investors who face lower tax rates on dividends. In contrast, investors in
low-yield stock are those facing high taxes on dividends. For these high tax payers, the after tax value of
the dividend is substantially less than the amount actually received (D) and the required compensation
for receiving the dividends is therefore higher. Elton and Gruber (1970) divide their sample, of 4148
stock listed on the NYSE which paid dividend in the 12 month period from 1 April 1966, into 10 groups as
per the value of the dividend yield. They find that tax brackets are negatively related to firms͛ dividend
policies. This is supportive of the tax clientele effect and suggests that a change in dividend policy rather
then the dividend policy itself could affect value. Nevertheless, the Elton and Gruber (1970) approach to
inferring the existence of a tax induced clientele effect has been criticised on a number of points. First, it
has been suggested that an observed ex-dividend-day-premium (i.e. a price drop, which is less than the
dividend amount) could be the result of factors other than a reflection of marginal taxes. Second, it has
been argued that short term trading could obscure tax clientele effect on ex-day returns even if tax
clientele exists. Third, it is claimed that the volatility of equity prices invalidates inferences about tax
effects from ex-dividend-day price behaviour.
Frank and Jagannathan (1998) address the first point. Namely, that ex-dividend day price behaviour may
not necessarily be the result of a tax clientele effect. It is shown that prices fall on ex-dividend days by
less than the value of the dividend even in markets where there are no taxes on either dividends or
capital gains. The ex-day premium therefore does not reflect the tax rate faced by the stock͛s clientele
but is explained by the costs associated with collecting and reinvesting the dividends. The study by Frank
and Jagannathan (1998) examine 1,896 cash dividend payments by 351 firms listed on the Hong Kong
Stock Exchange between 1980 and 1993. The sample is split into a low-dividend group and a high-
dividend group. The percentage price drop on the ex-dividend day is regressed on the dividend yield for
the full sample as well as for the sub samples of low and high dividends. The regression is based on a
model of the form
&-'.((+2& /    '      =
((-?&i'        X
Where  and 
are the prices on the last cum dividend trading day and on the first day on which the
stock is traded ex-dividend respectively. Ʌ is the ratio of rational to total traders; SPREAD is the average
bid-ask spread around the ex-dividend day expressed as a percentage of the cum-price. The slope
coefficient, , represents the value of the dividend to market makers.
Frank and Jagannathan (1998) find support for the notion that rational traders try to avoid receiving
dividends due to their lack of skill and experience in collecting and reinvesting these payments relative
to market makers. Subsequently, on the last cum-day there is a selling pressure while on the ex-day
there is a buying pressure. This results in a price drop that is smaller than the value of the dividend and
this is reflected in the negatively signed constant. As the dividend amount increases, Ʌ also increases for
the reason that of the wealth implications of ignoring the dividends. As Ʌ rises, the ex-day premiums
increase and this is reflected in the observation that for the high-dividend sample the constant is larger
in absolute value. Nevertheless, even for the low-dividend group, where Ʌ can be expected to be at its
lowest, the price drop is still lower than the value of the dividend as the constant is significantly
different from zero. Finally, the slope ɴ is significantly lower than one for the low-dividend sample but
insignificantly so for the high-dividend sample. This indicates the ability of market makers to benefit
from economies of scale in handling the dividends.
While Frank and Jagannathan (1998) address the first criticism of Elton and Gruber (1970), namely that
ex-dividend-day-premiums are not necessarily a reflection of marginal taxes, Koski and Scruggs (1998)
address the second criticism. Namely this is the criticism that short term trading may reduce or
eliminate (depending on the level of trading costs) the tax effect on ex-dividend-day prices. Thus the
Koski and Scruggs (1998) approach is based on what Allen and Michaely (1995) term a dynamic
taxclientele effect which comprises investigating trading volume around ex-dividend days. The argument
put forward is that short-term trading, motivated by traders exploiting exdividend day premiums, results
in abnormal trading volume. Therefore, even if the existence of a tax clientele can not be inferred from
ex-dividend day premiums, it can still be inferred from abnormal trading volume around the dividend
payment days. If taxes impact ex-dividend returns then security dealers, who are tax neutral, will
increase their trading around ex-dividend days. Also, if low dividend-yield stock is held by dividend
averse investors (as predicted by the clientele effect) then it should be associated with ex-day
premiums. Under such circumstances security dealers are expected to take long positions to capture the
dividends. (They will increase their cumdividend buying and sell at the ex-dividend price, which will drop
by less than the value of the dividend they collected). Similarly for high-dividend yield stock, held by
investors with preference for dividends, the ex-dividend price is expected to drop by more than the
nominal amount of the dividends. In that case, dealers can be expected to take short positions.
Furthermore, as US firms were exempt from taxes on 70% of their inter- corporate dividends received
during the period investigated, they are also expected to engage in dividend capturing by establishing
short positions. Koski and Scruggs (1998) collect data on trading volume by dealers and by
individuals/firms for 70 ex-dividend days between November 1990 and January 1991.

The abnormal trading volumes on the ex-dividend day and on the previous day are based on an event
window of 11 days centred on the ex-dividend date. Abnormal trading volume is obtained as actual
volume less the average volume during normal trading period and is standardised by the standard
deviation of the normal trading volume. The means of the standardised abnormal volumes provide
strong evidence that tax-neutral securities dealers engage in short selling of high yield stock around ex-
dividend. The study further tests the hypothesis that abnormal trading volumes around ex dividend days
are positively related to the dividend yield and negatively related to transaction costs. Results of the
ordinary least squares regressions of the standardized abnormal volume on the last cum-dividend day
indicate that securities dealers engage in short term trading on cum-dividend days. This is supportive of
a dynamic tax clientele effect as per which tax-neutral dealers engage in trading around the ex-dividend
date in order to capture tax-driven differences between the ex-dividend capital loss and the amount of
dividend paid. Nevertheless, it is precisely this arbitrage activity by securities dealer that can eliminate
tax clientele effect on ex-dividend day returns. Thus Koski and Scruggs (1998) address the second
criticism of the Elton and Gruber (1970) approach by showing that short term trading could obscure tax
clientele effect on ex-day returns. Green and Rdyqvist (1999) address the third criticism of the Elton and
Gruber (1970) approach, namely the notion that equity price volatility invalidates inferences about tax
effects from ex-dividend-day price behaviour. They do this by studying ex-day price behaviour of
Swedish lottery bonds, which are more stable than equity shares, thus reducing noise from ex-
distribution price behaviour.
Nevertheless, while more stable than equity shares, lottery bonds are similar to equity shares as there
are tax implications to whether the bond is sold cum-lottery or ex-lottery. Particularly, if the lottery
bond is sold on the cum-lottery day, the extra payment to the seller forms part of the bond price and is
treated as capital gains not as accrued coupon payment. Moreover, for the buyer the extra payment is
treated as a capital loss and form part of his/her tax basis. The implication of this feature of the lottery
bond is that, if tax differentials on capital gains and distributions matter, then ex-lottery returns, like in
the case of equities, should reflect the marginal tax rates of their holders.
Green and Rdyqvist (1999) note that another advantage of looking at the Swedish lottery bonds is that
distributions are tax-exempt. In most cases, where the tax system favours capital gains, factors such as
transaction costs of handling dividends can substitute for the effects of taxes, making ex-days behaviour
difficult to assess. In the lottery bonds market such factors have an opposite effect to that of taxes for
the reason that the tax system favours distributions. These non-tax factors, such as transaction costs,
may therefore reduce the effects of taxes on lottery-bonds ex-day price behaviour, but they do not offer
potential alternative explanation for them.
The data in Green and Rdyqvist (1999) comprise 46 lottery bonds of two types (mixed and sequenced)
with between 5-10 years to maturity, trading on the Stockholm Stock Exchange in the period 1986 to
1997. There are 455 lottery payments with 287 lottery days (due to lotteries that pay their coupons on
the same days). The sample is sub-divided as per the tax regime at the time when they were issued. The
oldest sample, issues pre-1981, has the largest tax advantage as capital losses on these bonds can be
fully used to offset tax due on any other income. Cumulative abnormal trading volumes of 10 days
around the ex-distribution day are calculated for each tax regime sample. Abnormal volume is calculated
as that day͛s volume divided by the average daily volume over the period beginning 6 trading days after
the previous distribution and ending 6 days before the current distribution. In a similar manner, 20 days
cumulative abnormal trading volumes are also obtained. Green and Rdyqvist (1999) find evidence of
high abnormal trading volumes for lottery bonds issued under all tax regimes, but the highest abnormal
volumes are recorded for the pre-1981 sample. This evidence is supportive of the dynamic tax clientele.
There is an increase in trading activity around distribution days due to tax differentials amongst market
participants, and this abnormal activity is stronger, the higher the tax benefits attached to the bonds. To
further investigate how taxes influence the returns around lottery days, these returns are regressed on
the coupon yield as in the following model:
&+'-(&v´'+&v,-,'        | 
v´(&'.&,- '          ||
v,(- .&,- '          
|

Where P(t+k) is the price on day (t+k) and  is the price on day . Thus the LHS of Equation (5.10) is the
change in price over the period .
Similarly, on the RHS, k is the number of days in the trading period and the coefficient ɶ0 is defined by
Equation (5.11), where
+
, is the expected after-tax daily return and  is the tax rate faced by the
marginal investor. So the first expression on the RHS of (5.10) is the pre-tax expected return over the
period . The second expression on the RHS of (5.10) is the pre-tax change in price that is due to the
coupon payment, . The coefficient ɶ1 is defined in Equation (5.12), thus the implied tax rate, , can be
obtained from the estimates of ɶ1.
When (ɶ1-1) is equal to ʹ1 (i.e. ɶ1 is equal to 0), the pre-tax price on the ex-coupon day falls by , the
value of the coupon, providing evidence of tax irrelevancy. When (ɶ1-1) is greater than ʹ1 (i.e. ɶ1 is
greater than 0), then the pre-tax price on the ex-coupon day falls by less than , the value of the
coupon. This provides evidence in support of the view that taxes drive coupon payment to be worth less
than their nominal amount.
When (ɶ1-1) is less than ʹ1 (i.e. ɶ1 is less than 0), then the pre-tax price on the ex-coupon day falls by
more than , the value of the coupon. This provides evidence in support of the tax advantage of coupon
payments, and is also the hypothesis put forward for empirical testing. To empirically test for the value
of ɶ1,  is added to both sides of Equation (5.10), which is then dividend through by  :
(v´+v,.         |
()&+'+%*.        |/
Where R is the pre-tax return over the trading period, , as defined in Equation (5.14), and < is the
coupon yield. Green and Rdyqvist (1999) run the Weighted Least Squares regressions on the two types
of lottery bonds. The findings of a negative ɶ1 imply that the price on the ex-lottery day falls by more
than the value of the coupon. This is consistent with the tax clientele effect in markets where
distributions have tax advantages. Thus, to summarise the evidence on the tax clientele effect, Green
and Rdyqvist (1999) find support for Elton and Gruber (1970) proposition that clientele effects can be
observed from ex-days price behaviour. Nevertheless, the implications from Koski and Scruggs (1998) is
that short term trading may eliminate the tax clientele effects on ex-day returns even if investors
consider taxes when choosing stock. In contrast Frank and Jagannathan (1998) note that price behaviour
around ex-days may be driven by factors other than tax clientele effects.
"


 
  
 
  


 

 
 

The signalling hypothesis is based on the notion of asymmetric information particularly between
managers and investors. Under this assumption dividend changes are valuable in that they convey
information about the firm͛s prospects. Indeed, Lintner (1956) observes that managers are more willing
to raise rather than reduce dividend levels, and this has been widely interpreted as indicating that
dividend decreases are associated with negative signals while dividend increases signal positive news.
rut what precisely is the nature of the information contained in dividend changes?
The risk-information hypothesis claims that dividend increases signal risk reduction. Alternatively, as per
the cash flow signalling hypothesis, dividend changes contain information about future cash flows.
Another opinion is that dividend changes signal permanent shifts in current earnings. In any event, as
noted by Allen and Michaely (1995), regardless of the precise information contained in the dividend
signal, there are principally two conditions that have to be met in order for the signaling hypothesis to
be valid.
The first condition requires that market participants understand dividends as signals. For instance, if the
unexpected dividend change signals future earnings changes, then market participants should revise
their future earnings forecasts following the dividend announcement. More generally, if unexpected
dividend changes are interpreted as signals of new developments in the firm͛s prospects, then a price
reaction should be observed in the same direction as the unexpected dividend change announced. The
second condition that have to be met to validate the signalling hypothesis, is that the dividend change is
followed by a change in the same direction in earnings or other firm͛s characteristics that the dividend
change is assumed to predict. Empirical methods in studies of the signalling hypothesis have therefore
focused on assessing the extent to which these conditions are met.
The following empirical review looks at each of these two conditions in turn. It begins with studies that
are concerned with assessing market interpretation of the dividend signal. This first condition is
commonly tested by event studies around the announcement period and by studying analysts͛ earnings
forecasts revisions. The validity of the second condition is then assessed, by reviewing empirical
evidence on actual changes in firm͛s characteristics following dividend change announcements.
Finally, some empirical studies of the conditional signalling hypothesis are discussed. The conditional
signalling hypothesis proposes that the dividend signal is conditional on firm specific characteristics. This
implies that both the interpretation of the dividend signal, and actual long-term changes in the firm
following the signal, are conditional on firm characteristics. Thus empirical evidence on the conditional
signaling hypothesis looks at cross sectional variations in the immediate reaction to dividend
announcements. It further looks at variations in long term changes in performance and other
characteristics following dividend changes. These cross sectional variations are tested either by
comparison analyses or by regression analyses.
     
  


Interpretation of the dividend signal is typically assessed by event studies around the dividend change
announcement period as has been done by numerous papers. Nevertheless, Laux, Starks and Yoon
(1998) and Howe and Shen (1998) innovate by studying price reaction of rivals of firms that announce
dividend changes. roth these studies use US firms and define the event window as the two days
including the day of the dividend change announcement and the previous day. roth also utilise the
market model, estimated post event, to generate abnormal returns. Laux, Starks and Yoon (1998) study
dividend announcements in the period 1969-1988, but restrict observations to dividend changes of at
least 25 percent. They calculate the averages of the cumulative two-day abnormal returns across the
sub samples of firms declaring dividend increases and firms declaring reductions. Consistent with the
signalling hypothesis, it is found that firms experience significant abnormal reactions at the time of the
announcement and in the same direction. Particularly, the mean two-day abnormal reaction of the 217
firms declaring dividend increases is significant at 1.01 percent. In contrast, the mean abnormal reaction
of the 105 firms announcing dividend decreases, is significant at ʹ6.35 percent. Further, the findings that
the reaction to dividend reductions is stronger than for dividend increases confirm Lintner͛s (1956)
observation of managers͛ particular dislike for dividend cuts. Laux, Starks and Yoon (1998) also try to
determine the information that market participants perceive to be contained in the dividend change
announcements. They do this by looking at the price reaction of non-announcing firms to dividend
change announcements by firms in the same industry. Specifically, it is proposed that rivals͛ price
reaction should be of the same direction as that of the announcing firm if the dividend change
announcement is interpreted as indicating industry-wide information (contagion effect). In contrast, if
the announcement is interpreted as signalling a shift in the competitive position of the announcer then
the price reaction of rivals should be in the opposite direction (competition effects). The two-day
average abnormal return, for 1,243 firms, rivals to dividend-increasing firms, is recorded at 0.05 percent
while for 667 firms, rivals to dividend-decreasing firms, the corresponding figure is ʹ0.32 percent. As the
price reaction of rivals is in the same direction as that of the announcer, this indicates that
announcements are interpreted as containing information about common factors for the industry as a
whole.
Nevertheless, Laux, Starks and Yoon (1998) note that dividend change announcements may also contain
information about shifts in the competitive balance in the industry. First, the average reactions of rivals
to dividend change announcements are not significant, which may be the result of contagion and
competition effects offsetting each other. Second, it is found that rivals͛ same-direction reactions are
strongest for those rivals least likely to be affected by changes in the competitive position of the
announcer. Specifically, the most competitive rivals display a significant positive reaction to increase
announcements while the least competitive rivals display a significant negative reaction to decrease
announcements.
Howe and Shen (1998) also investigate market͛s interpretation of the nature of the dividend signal by
studying non-announcing rivals. The sample used in the study consist of rivals of dividend initiating firms
traded on the NYSE/AMEX, in the period 1968 to 1992. The price reaction and analysts͛ forecast
earnings revisions, following dividend initiation announcements by rival firms in the same industry, are
analysed. The average announcement period͛s two-day cumulative abnormal price reaction of 3540
rivals is recorded as insignificant at ʹ0.07 percent. Similarly analysts do not revise their earnings
forecasts for rivals of announcing firms. The mean, unadjusted, earnings forecast revision across 345
rivals of dividend initiating firms is insignificant at 0.1677, while the mean abnormal forecast revision is
insignificant at 0.167121. It is thus concluded that the information contained in the initiation
announcement is interpreted as firm specific without any evidence of intra-industry contagion or
competition effects. Thus the findings in Howe and Shen (1998) are not fully consistent with those in
Laux, Starks and Yoon (1998). Particularly, while Laux, Starks and Yoon (1998) show that dividend
change announcements signal information about rivals of the announcers, Howe and Shen (1998) do not
support this view. Nevertheless, evidence in Laux, Starks and Yoon (1998) supports the validity of the
first condition for the signalling hypothesis to hold, namely that dividend changes are interpreted as
signals. As the first condition is shown to be valid, the question is whether the second condition is also
met. Particularly for the second condition to be valid, the dividend change announcement should be
followed by actual changes in the firm characteristics, which the dividend change is predicted to signal.
This is the subject to be discussed next.
¢


 


 
  

 
Assessing actual changes in firms͛ characteristics, following dividend change announcements is the
subject of various empirical studies. This is for the reason that the findings that dividend change
announcements are followed by particular changes in the firm may help in establishing two things. First,
it confirms the validity of the signalling hypothesis for the reason that it makes sense to interpret the
dividend change as a signal of an unexpected change if indeed it is followed by such a change. Second, it
can shed light on the precise nature of the information contained in the announcement. DeAngelo
DeAngelo and Skinner (1996) investigate whether dividend change announcements are followed by
changes in earnings that are in the same direction. In order to isolate the effects of the signalling
hypothesis from other effects that may influence firms͛ dividend policy, DeAngelo DeAngelo and Skinner
(1996) select firms experiencing a sudden earnings decline after a long period of stable growth. In
particular, the sample contains 145 US firms experiencing a decline in annual earnings between 1980
and 1987 after consistent earnings growth over at least nine years. This selection method ensures that
the dividend change is a signal of future rather than past changes. The selection method also implies
greater need for signalling for the reason that firms that expect the current decline to be corrected in
the near future, have to convey this information to market participants.
The initial results in DeAngelo DeAngelo and Skinner (1996) do not support the signalling hypothesis of
dividends, as there is no indication that dividend increases represent reliable signals that the current
earning problem is only temporary. Specifically, it is found that the 99 firms that increased their
dividends in the first year of the earnings decline experienced no positive abnormal earnings in the
subsequent three years. To further investigate the robustness of these results, DeAngelo DeAngelo and
Skinner (1996) use 135 firms with complete earnings data, and regress the abnormal future earnings on
a dividend signal and a number of control variables assumed to help in predicting future earnings. They
find the coefficient on the dividend signal to be insignificantly different from zero and this result holds
when alternative proxies for the dividend-signal are used. Thus the results from the regression analysis
confirm the earlier findings that dividend increases are not a reliable signal of improved future earnings
performance.
Two possible explanations are offered in DeAngelo DeAngelo and Skinner (1996) for the unreliability of
the dividend signal. The first is mangers͛ tendency to send overoptimistic signals either naively or
deliberately. Second, it is suggested that the cash commitment associated with the dividend increase is
relatively small. The median firm͛s dividend increase in the year of the earnings decline, amounts to only
3.5 percent of earnings, hence weaker firms can afford to send misleading signals. A similar figure of 5
percent of earnings is recorded in Lipson, Maquieira and Meggison (1998) with respect to the dividend
initiations of newly listed firms.
Lipson, Maquieira and Meggison (1998) compare the performance of 99 newly public US firms that
initiated dividends in the period 1980 to 1986, with similar firms that did not. The argument for the
choice of newly listed firms is similar to that of DeAngelo DeAngelo and Skinner (1996) for choosing
firms experiencing earnings decline after a long period of earnings growth. Specifically, it is noted that
the need for signaling as a way of distinguishing quality may be more significant for these firms. Indeed,
it is found that earnings surprises in the first and second years following dividend initiations are
significantly greater compared with similar newly listed firms that did not initiate dividends.
Furthermore, the dividend cash commitment represents about 5 percent of earnings of the newly listed
firms that initiated dividends. This is significantly lower than 8.5 percent of earnings that similar non-
initiating firms would have had to commit to, if they wanted to match the dividend yield, dividend to
sales ratio or dividend to assets ratio of initiating firms.
Thus, Lipson, Maquieira and Meggison (1998) provide support for the view that dividend initiations
signal future earnings prospects, as they distinguish one newly listed public firm from another newly
listed firms. Nevertheless, it is also shown that dividend initiations do not distinguish newly listed firms
from established firms in the same industry. This provides partial support for the signaling theory and
for the second condition, namely that the dividend changes are followed by actual changes in the firm͛s
characteristics. It is, nevertheless, inconsistent with DeAngelo DeAngelo and Skinner (1996), as is the
conclusion that dividend initiations are a valid signal of future performance, for the reason that weaker
firms would find the implied resource commitment, required in order to match the actions of quality
firms, too costly to mimic. Thus more evidence is needed on the question of whether dividend changes
are a reliable signal, and this is provided in renartzi, Michaely and Thaler (1997).
renartzi, Michaely and Thaler (1997) take an empirical approach similar to DeAngelo DeAngelo and
Skinner (1996), comparing the unexpected earnings of firms that changed their dividends with those
that did not. The sample contains 7186 firm-year observations of 1025 US firms that trade on the NYSE
or the AMEX for at least two years during the period 1979 to 1991 and which meet various other
requirements. The hypothesis is that firms that increase their dividends in a given year should enjoy
positive unexpected earnings in years that follow. Similarly, firms that decrease their dividends in a
given year should experience negative unexpected earnings in years that follow. renartzi, Michaely and
Thaler (1997) also investigate variation in the unexpected earnings across dividends increasing firms.
The hypothesis is that if signaling is costly, then the larger the dividend-increase, the greater should the
unexpected earnings in the following year be.
Results in renartzi, Michaely and Thaler (1997) show a strong contemporaneous correlation between
dividend changes and earnings changes. Firms that increase their dividends in year 0, experience
earnings increases in that year, which are significantly higher than the mean earnings change of the
group of firms that did not change their dividends. Similarly, firms decreasing their dividends,
experience significantly more severe earnings decreases in the same year compared with the group of
firms that did not change their dividends. Nevertheless contrary to the signaling hypothesis no
correlation is found between the sign and size of dividend increases in a given year, and earnings
changes in future years. Furthermore firms that cut dividends in a given year, experience significant
earnings increases in the following year. Thus the results in renartzi, Michaely and Thaler (1997) are
supportive of DeAngelo DeAngelo and Skinner (1996), as they also reject the link between dividend
changes and unexpected future earnings growth. This rejection of the traditional interpretation of the
signaling hypothesis is also the conclusion in Jensen and Johnson (1995). Nevertheless, what set Jensen
and Johnson (1995) apart from these studies is that they concentrate specifically on dividend decrease
announcements rather than on dividend changes. The study investigates whether firms reducing
dividend by at least 20 percent after twelve consecutive quarters of positive, non-decreasing dividends,
also experience a decline in earnings.
The sample in Jensen and Johnson (1995) consists of 268 observations of 218 reductions and 50
omissions by 242 different US firms in the period 1974 to 1989. It is found that while earnings decline
significantly in the period before the dividend cut they rise significantly afterwards. The stock price,
nevertheless, is found to drop at the time of the dividend reduction announcement and this is explained
by the observation that although the cut marks a turning point in earnings pattern, there are still
lingering problems. For instance, it is observed that the earnings level at the end of the second year
after the dividend cut is still below its level three years before the cut. The study thus proceeds to assess
the nature of the problem more closely.
To do that, and to investigate the precise information the reduction announcements contain, Jensen and
Johnson (1995) look at a range of changes in various other firm͛s financial variables. The patterns of
these variables over the three years before and three years after a dividend reduction are examined.
Findings indicate that firms use the funds, saved from the dividend cut, to improve their positions. The
dividend cuts thus lead to improvements in liquidity position and to reduction in the level of debt. The
conclusion is that dividend reductions do not necessarily signal a decline in earnings. Rather such cuts
appear to signal the beginning of restructuring activities and a turn around in financial decline.
Thus the implications of Jensen and Johnson (1995) are similar to those of Lipson, Maquieira and
Meggison (1998) in the sense that both provide some evidence to support the notion that dividend
changes are followed by actual changes in the firm. Nevertheless, both also illustrate that dividend
changes should not be simply interpreted as signalling future earnings increases or decreases.
Furthermore, such a blanket view on the nature of the dividend signal is strongly rejected in DeAngelo
DeAngelo and Skinner (1996), and in renartzi, Michaely and Thaler (1997). Results from these studies
clearly call for further investigation into the precise nature of the information contained in dividend
change announcements. Alternative hypotheses, which have been put forward, comprise the
permanent earnings hypothesis, the cash flow hypothesis and the risk information hypothesis. Some of
the relevant empirical work in these areas is discussed below.
     
   
         
  
The permanent earnings hypothesis proposes that changes in dividends do not necessarily signal future
growth or contraction in the levels of current earnings. Instead, announcements of dividend changes
contained information about permanent as oppose to temporary shifts in current earnings. This view is
consistent with the survey findings by Lintner (1956) and with Lee (1996) who finds that the partial
adjustment model performs better when the target dividend is expressed as a function of permanent
earnings.

Lintner (1956) finds that mangers tend to smooth dividends, and this tendency is reflected in the partial
adjustment model. Indeed, the model can be manipulated so as to express dividends in terms of a
weighted-average of current and past earnings. Thus as per this model, dividend trends reflect the
smoothed pattern of current earnings, eliminating transitory fluctuations. A signalling theory
interpretation of this is that by smoothing out temporary fluctuations in the factors that determine
dividends, the dividend pattern reflects the stable pattern of those factors. As it is current earnings,
which determine dividend levels in the partial adjustment model, a dividend change has to be the result
of a permanent shift in current earnings. The second part of renartzi, Michaely and Thaler (1997)
assesses the hypothesis that dividend changes signal earnings stability rather than future earnings
growth. The study compares the likelihood of a dividend-increasing firm experiencing a decline in its
following year͛s earnings with the probability of a firm that does not change its dividends to experience
such an event. The results indicate that compared with firms that maintain their dividend levels,
dividend-increasing firms are less likely to experience unexpected declines in earnings at least in the first
year after the dividend change. As no correlation is found between dividend increases and future
earnings changes, the conclusion arrived at is that dividends do not signal unexpected future earnings
increases.
Instead, it is concluded that, consistent with Lintner (1956), dividend increases signal that current
earnings levels are permanent. This distinction between permanent and temporary changes is also
explored in rrook, Charlton, and Hendershott (1998). That study, nevertheless, is based on the
hypothesis that dividend changes contain information about cash flow rather than about earnings. This
is the cash flow signaling hypothesis, which proposes that dividend changes signal changes in expected
cash flows.
rrook, Charlton, and Hendershott (1998) investigate this hypothesis and in particular whether dividend
changes signal permanent as opposed to temporary changes in firms͛ cash flows. For that purpose a
sample of non-regulated, US firms is divided into three groups on the basis of expectations regarding
changes in cash flows in years 1 through 4 where 1992 is year 029. Classification into groups is then
carried out as follows. The first group, the permanent-increase group, contains 101 firms whose cash
flows remain at least 30% above year 0 in each of the subsequent four years. The second group, the
temporary-increase group, contains 45 firms whose cash flows increase by at least 40% in year 1 but
then fall to less than 20% above year 0 level in either of the subsequent two years. The third group, the
no-increase group, consists of 34 firms whose cash flows increase by less than 30% over the four-year
period and by less than 15% in each year.
Results from the comparison analysis in rrook, Charlton, and Hendershott (1998) are consistent with the
notion that firms use dividends to signal a permanent increase in cash inflows. Specifically, it is reported
that the permanent-increase group͛s average dividend per share changed by 16.5 percent in year 0,
before the cash flow increase. This is significantly larger than the 6.8 percent change experienced by the
temporary-increase group. Furthermore, comparing annual abnormal stock returns, across the three
groups, indicates that the dividend signal is understood by market participants. The permanent increase
group experiences an average annual stock return, net of the CRSP value weighted index, of 17.5
percent in year 0. This is statistically different from zero, and statistically different from the 6.5 percent
experienced by the temporary-increase group. Thus consistent with the cash flow signalling hypothesis,
rrook, Charlton, and Hendershott (1998) find a positive link between increases in permanent cash flows,
dividend rises and stock price reaction. Firms expecting a permanent improvement in their cash flows,
signal this information by increasing their dividends. The market understands the signals and the stock
price rises before the actual cash flow increase occurs.
Thus while renartzi, Michaely and Thaler (1997) suggest that dividend changes signal changes in
permanent earnings, rrook, Charlton, and Hendershott (1998) find it is permanent cash flows that
dividend changes signal. In both cases, nevertheless, dividends are used to signal changes in the pattern
of long-term performance. An alternative explanation is that dividend changes signal information about
changes in the firm͛s risk. This is the risk information hypothesis, which is investigated in Dyl and
Weigand (1998). In particular, Dyl and Weigand (1998) distinguish the risk information effect by
investigating whether dividend initiation announcements are followed by reduction in earnings volatility
and risk or by earnings increases. The sample in Dyl and Weigand (1998) consists of 240 firms listed on
the NYSE/AMEX, and which initiated dividends during the period 1972 to 1993. In order to assess the
change in risk following dividend initiations, the total risk of returns, market risk of returns and earnings-
per-share volatility, before and after the dividend initiation, are compared. Thus proxies for these
variables are calculated for each firm in respect of the period before the dividend initiation and in
respect of the period after the initiation.
The means and medians for each of these proxies are obtained and the significance of the change from
the pre-initiation period to the post-initiation period is assessed. Dyl and Weigand (1998) find that 70
percent of the sample firms have lower variances in the post dividend initiation period. Furthermore,
the hypothesis of equal mean variances before and after the dividend initiation is rejected. Likewise, 68
percent of the sample firms have lower market risk as measured by ɴ after the dividend initiation and
the difference in the mean ɴ pre and post initiation is statistically significant. There is also evidence to
show that earnings volatility declines in the period following the dividend announcement, as the post-
initiation earnings volatility is significantly lower compared with the pre-initiation period. In contrast,
nevertheless, there is no significant difference in the mean of the standardised earnings per share in the
pre- and postinitiation periods. Thus, it appears that announcements of dividend initiations are not
followed by increases in future profitability.
rased on their findings Dyl and Weigand (1998) conclude that announcements of dividend initiations do
not signal enhanced profitability, but instead they are signals of stability. This risk-information
hypothesis of dividend signalling is particularly interesting as it highlights a weakness in the bird in the
hand argument in favour of generous dividends. Accordingly, the reason that stock price reaction to
dividend increases is typically positive, this is not for the reason that dividend cause risk reduction, but
for the reason that they are signals of risk reduction and future stability. From the discussion in this sub
section it emerges that the nature of the information, conveyed from the dividend change
announcement, is ambiguous. The studies by renartzi, Michaely and Thaler (1997) and rrook, Charlton,
and Hendershott (1998) conclude that dividend signal shifts in permanent as opposed to transitory
performance. Although the emphasis in the former study is on earnings performance while in the latter
it is cash flow, over the long-term these are essentially the same. These conclusions tie-in well with
Lintner͛s (1956) observation that managers seek to achieve a gradual upward progression in dividends
that reflect long-term, permanent changes in performance. In contrast, Dyl and Weigand (1998) find
that dividend changes indicate shifts in risk and earnings volatility rather than changes in performance.
A possible resolution for this confusion is the idea that dividend changes convey different information to
different firms. The reaction to dividend-change announcements therefore depends on particular
characteristics of the announcing firm and its circumstances. This hypothesis is termed the conditional
signalling hypothesis and is typically investigated by cross sectional comparisons, or by regression
analysis where firm characteristics are entered as explanatory variables.
  




 
Researches have investigated three main factors that may cause variations in the signalling function of
dividends across firms or even over time for the same firm. First, such variations may be due to the
combination of activities with which the firm engages prior to the dividend change announcement.
Second, variations in the meaning and interpretation of the dividend signal may be caused by
differences in the environment in which the firm operates. Third, cross sectional differences in the
meaning of the dividend signal may be the result of differences in firms͛ characteristics. The discussion
that follows presents some of the empirical work on each of these three factors, namely, prior activities,
the environment and firm͛s characteristics.
Related to the first factor, the effect of prior activities on the dividend signal, is the idea that the value of
the dividend signal depends on the surprise with which it is met by market participants. For instance, a
dividend change announcement that comes after certain activities, such as the publication of earnings
data, may be less informative than if such prior activity did not occur. Similarly, a dividend change
announcement that follows a particular activity may contain different information than if it came after a
different activity. The first issue is dealt with in ralachandran, Cadle and Theobald (1999), while the
second issue is the subject of rorn and Rimbey (1993).
rorn and Rimbey (1993) argue that financing activity, undertaken prior to dividend increase
announcements, can distinguish dividend increasing firms with future growth prospects from those
firms that disinvest. The study investigates this hypothesis by regression analysis methodology of the
price reactions to surprise dividend increase announcements. To ensure only surprise and hence
informative increases, enter the sample, the selection procedure imposes the restriction that only firms
initiating or resuming dividends after at least ten years of omissions are comprised. This selection
procedure results in a sample of 490 US firms that have initiated or resumed dividend in the period 1962
to 1989. For these firms the whole of the dividend is taken as unexpected. The sample is then
partitioned on the basis of whether the firm has been engaged in financing activity in the twelve months
prior to the dividend change announcement. This provides a sub sample of 102 firms that were engaged
in prior financing activity, and a sub sample of 388 firms that were not.
rorn and Rimbey (1993) begins their empirical investigation by running separate regressions for each
sub sample, of the reaction to the dividend increase announcement on a constant and the dividend
yield35. Results indicate that the intercept is lower for the sub sample of prior-financing firms compared
with the sub sample of non-financing firms. This is consistent with the notion that prior financing activity
leads to partial anticipation of a dividend increase, which impacts the share price prior to the actual
increase announcement. Results also show that for the sub sample of prior-financing firms, the
abnormal return per unit of dividend yield is much larger than for the nonfinancing firms. (2.800 as
oppose to 1.745). This is consistent with the notion that prior financing activity alters market reaction to
dividend increase announcements as it distinguishes firms with good growth prospects from those with
poor growth opportunities.
rased on these results rorn and Rimbey (1993) proceed to assess the effect of the size of the prior
financing activity on the reaction to the dividend announcement. Utilising the sub sample of prior-
financing firms only, the price reaction to the dividend announcement is regressed on the dividend yield
and on the financing yield. The estimated coefficient on the financing yield is shown to be positive and
significant. This is taken to indicate that the larger the amount of finance, raised prior to the dividend
increase announcement, the stronger is the positive price reaction to the announcement. Thus rorn and
Rimbey (1993) conclude that a dividend increase announcement that follows prior financing activity, is
interpreted as a stronger indication of growth compared with announcements that do not follow such
activity. Nevertheless, the prior activity also reveals information and results in anticipation of a dividend
change, therefore the actual dividend change announcement has less informative value. This last point
is further taken in ralachandran, Cadle and Theobald (1999), who also investigate the effects of prior
activities (albeit not financing) on the dividend signalling function. ralachandran, Cadle and Theobald
(1999) look at the extent to which interim dividend reductions (IDR) announcements can be anticipated
from prior dividend cuts or other factor. It is proposed that anticipations of IDR should lead to weaker
price reaction on the announcement date compared to situations where these announcements come as
a surprise. To test this proposition, price reactions to IDR announced by 242 non-financial UK firms, in
the period 1986 to 1993 are studied. The study, nevertheless, begins by testing the traditional signalling
hypothesis assumption consistent with which the IDR announcements should lead to negative price
reactions. Indeed, the unadjusted mean abnormal return in the event window around the IDR
announcement is found to be negative and significantly different from zero across the five return
generating processes. In the next stage of the investigation, ralachandran, Cadle and Theobald (1999)
look at differences in price reaction between IDR that follow previous dividend reductions and IDR that
do not. To do this the sample of IDR announcements is divided into 142 First Interim Dividend
Reductions (FIDR) and 100 Subsequent Interim Dividend Reductions (SIDR). The hypothesis put forward
is that FIDR lead to more negative price reaction than SIDR for the reason that the former provide more
information to the market while SIDR are to some extent anticipated. Using the market model, the mean
unadjusted price reaction to FIDR announcements is recorded as significant at ʹ0.094 while reaction to
SIDR announcements is significant at ʹ0.053. As the difference between these reactions is significant,
the results support the hypothesis that price reaction to dividend signals are weaker the more they are
anticipated.
In the third stage of the investigation, ralachandran, Cadle and Theobald (1999) focus on SIDR
announcements. It is proposed that when the subsequent interim dividend reduction is greater than the
Prior Final Dividend Reduction (PFDR), the price reaction should be stronger compared with when the
SIDR is less than the PFDR. This may be the case if the increased dividend reduction at the interim stage
provide further information and is tested by splitting the SIDR sample into two groups. The first group
consists of 39 SIDR where the percentage dividend reduction is greater than the percentage PFDR, and
the second group consists of 61 SIDR where the percentage dividend reduction is less or equal to the
percentage PFDR. Using the market model, the mean unadjusted reaction when the SIDR is greater than
the PFDR is ʹ0.098, while when the SIDR is not greater than the PFDR the mean reaction declines to ʹ
0.025. Thus the results are supportive the proposition that price reaction should be stronger, the
stronger the surprise.
In the final stage of the investigation, ralachandran, Cadle and Theobald (1999) search for factors that
could explain cross sectional differences in price reactions to IDR. For this purpose, the cumulative
abnormal returns around the IDR, generated from the market model, is regressed on various variables
that are hypothesised to impact the surprise in the IDR. Results indicate that, consistent with signalling
hypothesis, the price reaction to the IDR is significantly related to the size of the reduction.
Furthermore, there are mixed results about the significance of changes in interim earnings in influencing
price reaction. This is consistent with the view that the dividend signal is valuable for the reason that the
information in the earnings change is a noisy signal of future performance. The regression results also
support the conditional signalling hypothesis and the notion that cross sectional differences may result
in variations in the signalling function of dividends. Particularly, the price reaction is significantly
influenced by whether the firm has previously reduced its dividends and by the gearing ratio. The
environment in which the firm operates also appears significant as the surprise in the IDR and thus the
price reaction to it, are influenced by prior dividend reductions by other firms in the industry.
The impact of the environment in which the firm operates on market interpretation of the dividend
signal is also the subject in Impson (1997). Nevertheless, the emphasis there is on differences between
regulated and unregulated firms. The hypothesis is that, due to the particular circumstances faced by
utilities, dividend reduction announcements by these firms result in stronger reaction than in the case of
other firms. The study uses 262 regulated and unregulated US firms declaring dividend
reductions/omissions between 1974 and 1993 and the Weighted Least Squares cross sectional
regression approach. Thus the price reaction to the dividend announcement is regressed on a regulated-
firm dummy and on control variables.
Results in Impson (1997) indicate that regulated utilities experience significantly more severe reaction to
dividend reduction announcements compared with unregulated firms. It is suggested that the surprise in
the dividend reduction announcements may be greater for regulated utilities as these firms have
traditionally been associated with high yields and stable pattern of dividends. Furthermore, the
coefficients on the Tobin͛s Q and size control variables are positive and significant. The former indicates
that the higher the over-investment, the more negative is the price reaction to the dividend cut
announcement. The latter indicates that the smaller the firm, the more severe is the reaction. Thus,
consistent with the conditional signalling theory, firm͛s characteristic and environmental factors are
found to be significant in explaining price reaction to dividend change announcements.
The significance of Tobin͛s Q and firm size recorded in Impson (1997), as well as the significance of the
gearing level recorded in ralachandran, Cadle and Theobald (1999), are suggestive of a link between
firms͛ characteristics and the dividend signal. Akhigbe and Madura (1996) investigate this issue further,
by assessing cross sectional variation in long-term price performance following dividend change
announcements. The study is based on a sample of US firms announcing dividend changes during the
period 1972 to 1990. Nevertheless, prior to assessing cross sectional variations in long-term
performance following dividend change announcement, a basic signalling hypothesis͛ prediction is
tested. This is the prediction that dividend increase signals should be realised by improvements in long-
term performance while decreases should be realized by future decline in performance. For this end, the
mean long-term price performance of 128 firms initiating dividends is compared to the mean for the 299
firms omitting dividends. Indeed, it is found that firms tend to experience a favourable share price
performance, over the longer term, following dividend initiations and unfavourable performance
following omissions.
To assess cross sectional variations in long-term price performance following dividend initiations and
omissions Akhigbe and Madura (1996) regress the 36-month cumulative abnormal return on firm
characteristics and the size of the dividend change. Results of this procedure indicate that larger cuts in
dividends are associated with more severe long-term price performance. Further, the coefficient on the
past profitability measure is negative and significant in the initiation sample, suggesting that firms with
inefficient management improve their performance following dividend initiations. With regards firm size
it is found that smaller firms tend to perform significantly better in the three years following dividend
initiations while large firms tend to perform significantly worse following dividend omissions. Finally,
long term reaction to dividend initiations is influenced by the Tobin͛s Q measure, implying that firms
that over-invest perform significantly better following dividend initiations. These findings are consistent
with the conditional signalling hypothesis and with the findings in Gombola and Liu (1999). Gombola and
Liu (1999) explore the link between Tobin͛s Q and the short-term price reaction to dividend increase
announcements. In particular, the study analyses the price reaction to 196 Special Designated Dividend
announcements made by US firms between 1977 and 1989. It is hypothesised that firms facing low
investment opportunities, with low Tobin͛s Q, should experience stronger price reaction to the
announcement of Special Designated Dividend. This is consistent with the signaling hypothesis, for the
reason that the surprise in the special dividend announcement should be greater for firms with little
investment opportunities. Indeed the event study methodology finds that the mean three-day
cumulative abnormal return around the Special Designated Dividend announcement for the low Tobin͛s
Q sample is positive and significant. Nevertheless, the mean price reaction for the high Tobin͛s Q sample
is insignificantly different from zero, while the mean difference between the two groups is significant.
The approach in Gombola and Liu (1999) is based on an earlier study by Lang and Litzenberger (1989).
roth studies investigate the validity of the conditional signalling hypothesis with respect to Tobin͛s Q,
but while the former focuses on price reaction to special dividend, the focus of the latter in on
substantial changes in regular dividends. As per the conditional signalling hypothesis the reaction to
substantial dividend change announcements should be larger for firms with low investment
opportunities. The rationale for this is explained as follows. Investors expect an increase in cash flows
for firms with good investment opportunities and they also expect these firms to announce dividend
increases to signal this. Therefore the reaction to dividend increase announcements should not be
strong for high Tobin͛s Q firms while the reaction to announcements of substantial dividend cuts should
be strong. In contrast firms without high investment opportunities are not expected to enjoy an increase
in cash flows, thus large dividend increases or decreases are not expected for low Tobin͛s Q firms. If such
dividend changes are announced, market reaction should be strong. Lang and Litzenberger (1989)
therefore predict that if the price reaction is measured as the average to all dividend changes (increases
and decreases), the average reaction in the case of low Tobin͛s Q firms should be stronger than for high
Tobin͛s Q firms. To test this prediction the study utilises 429 substantial dividend change
announcements made between 1979 to 1984 by US firms. To ensure the dividend change is substantial,
a restriction is imposed where the absolute value of the percentage dividend change of each
observation must be greater then 10%. The average reaction on the day of the announcement for firms
with Tobin͛s Q less than unity is recorded as 0.011, as opposed to 0.003 in the case of high Tobin͛s Q
firms. Further, the 0.008 difference in the mean reaction between low and high Tobin͛s Q firms is highly
significant.
Nevertheless, Lang and Litzenberger (1989) point out that a stronger price reaction to substantial
dividend changes by low Tobin͛s Q firms compared with high Tobin͛s Q firms is also consistent with the
over-investment hypothesis. Large dividend increases by firms with low investment opportunities
reduce the potential for over-investment by these firms. Such announcements should therefore be
received with more positive reaction compared with reaction to similar changes by firms that face many
investment opportunities. Similarly, large dividend decrease announcements by firms with low
investment opportunities indicate an increase in the probability of over investment by management.
Such announcements by low Tobin͛s Q firms should therefore be met by more severe reaction. Thus
similar to the conditional signalling hypothesis, the overinvestment hypothesis also predicts a stronger
reaction to substantial dividend increases or decreases by low Tobin͛s Q firms. To distinguish between
the conditional signalling hypothesis and the over- investment hypothesis, Lang and Litzenberger (1989)
further partition their sample of low and high Tobin͛s Q groups into dividend increase and dividend
decrease announcements. The reaction to announcements of substantial dividend decreases is the key
to distinguishing between the two hypotheses. Particularly, the conditional signaling hypothesis predicts
strong reactions to dividend decreases regardless of the firm͛s Tobin͛s Q, which is due to the negative
information such announcements contain regarding future expected cash flows. In contrast, the over-
investment hypothesis predicts that the reaction to dividend changes will always be greater for low
Tobin͛s Q firms for the reason that the potential for over-investment in the case of firms with little
investment opportunities is greater.
rased on this distinguishing feature between the two alternative hypotheses, Lang and Litzenberger
(1989) compare the mean price reaction to dividend decrease announcements. They find that the
average reaction to dividend decreases by high Tobin͛s Q firms is insignificant, at ʹ0.003, while for low
Tobin͛s Q firms the reaction is significant at ʹ0.027. These results indicate that there is a significant
difference in the price reaction to dividend cut announcements between firms with high and low
investment opportunities. These findings are consistent with the over-investment hypothesis and
inconsistent with the conditional signalling hypothesis. Similar results in support of the over-investment
hypothesis over the conditional signalling hypothesis are also obtained from comparing the post-
announcement revisions of analysts͛ current earnings forecasts.
Thus the results in Lang and Litzenberger (1989) in favour of an agency theory based explanation for
market reaction to dividend changes contradict the conclusions in Gombola and Liu (1999) in favour of
conditional signalling theory. Nevertheless, the results in Akhigbe and Madura (1996), Impson (1997),
and ralachandran, Cadle and Theobald (1999) are consistent with Gombola and Liu (1999). These
studies show that firms͛ characteristics, and in particular investment opportunities (Tobin͛s Q), are
significant in determining how the dividend signal is interpreted. Impson (1997) and ralachandran,
Cadle and Theobald (1999) further illustrate that environmental factors, such as whether the firm is
regulated or the dividend behaviour of other firms in the industry, also influence the price reaction to
the dividend signal. Finally, ralachandran, Cadle and Theobald (1999) and rorn and Rimbey (1993) show
that activities undertaken by the firm prior to declaring dividend changes have implications for how this
signal is interpreted. In particular, ralachandran, Cadle and Theobald (1999) show that prior activities
such as past dividend announcements by the firm, influence the amount of surprise and hence the value
of the dividend signal. Similarly, rorn and Rimbey (1993) show that past activities such as prior financing
can distinguish dividend initiating firms that signal quality from dividend initiating firms that disinvest.

"


 
    


  
h     
Agency theory predicts that managers abuse their position as agents of the firm to appropriate benefits
to themselves. A number of studies have investigated the validity of this assumption. Opler, Pinkowitz,
Stulz and Williamson (1999) show that managers tend to accumulate excess cash when they have the
opportunity to do so. Nevertheless, they also find that firms with excess cash do not use it to over-invest
as predicted by agency theory. There is also no evidence of reluctance by managers to return cash to
shareholders in the form of dividends when investment opportunities are low.
Similar conclusions are also reported in Long, Malitz and Sefcik (1994) who investigate the validity of the
agency cost of debt. In particular, the study investigates the under investment problem, which predicts
that firms will increase dividends following the issuance of debt as a means of expropriating wealth from
debt holders to equity holders. Nevertheless, Long, Malitz and Sefcik (1994) find no evidence to support
the view that firms act in a manner consistent with the wealth expropriation hypothesis. It is therefore
concluded that reputation has greater value to the firm and its management than the value of the
benefits to be obtained by a one off wealth expropriation.
If reputation is significant to managers and acting as predicted by agency theory can harm their
reputation, then it may be in managers͛ interests to show that the firm is free of potential agency
problems. One way for managers to create reputation, particularly in countries with poor protection for
minority shareholders, is by paying dividends which signals decent treatment of minority shareholders.
This idea is developed in La Porta, Lopez-de-Silanes, Shleifer and Vishny (2000) who term it the
substitute model of dividends. Nevertheless, La Porta, Lopez-de-Silanes, Shleifer and Vishny (2000)
reject the substitute model in favour of what they term the outcome model of dividends. In the
outcome model dividends are the outcome of effective pressure by minority shareholders and therefore
higher payout ratios tend to be observed in countries with good protection for minority shareholders.
Whether the motivation to pay dividends is due to the need by insiders to create reputation for good
treatment of minority shareholders, or is the outcome of pressure by minority shareholders, dividends
derive their value from reducing agency problems. Dividends can reduce agency problems by reducing
the free cash flows (Jensen, 1986) or by forcing the firm to the capital market thus inducing capital
market monitoring of the firm and its management (Easterbrook, 1984). Rozeff (1982) incorporates the
agency related value of dividends into a model, which he calls the cost minimization model and which
allows for empirical testing of the agency theory of dividends.
There are, nevertheless, other ways to control agency costs which may be less costly than the dividend
device. For instance, growing firms are likely to resort to external financing on a regular basis, and thus
subject themselves to external monitoring even without using dividends. Similarly Jensen (1986)
proposes that agency costs may be controlled by debt. Other alternatives to dividends in controlling
agency costs comprise managerial ownership and management compensation schemes that are
designed to align the interests of managers and outside shareholders. Indeed, Fama and French (2001)
propose that the declining trends in dividends by US firms may be due to growing use of stock options
by managers, which lower the benefits of dividends in controlling agency costs. Thus the availability and
cost of non-dividend monitoring mechanisms may impact the degree to which the dividend device is
used and thus the validity of the cost minimization model.
In light of the above discussion, the following selective review of empirical studies of the agency theory
of dividends is dividend into two sub sections. The first sub section describes some studies of the cost
minimization model. The second sub section is devoted to some of the studies that seek to assess the
degree of substitutability amongst the various methods by which firms can control agency costs.
  


+
  
Rozeff (1982) introduces the cost minimization model as per which the optimal dividend payout is at
the level that minimizes the sum of transaction costs and agency costs. Transaction costs are incurred
when external finance is raised, which may be necessary when internal funds are paid out as dividends.
Agency costs are the costs associated with the agency problem. These costs can be reduced by the
payment of dividends as suggested by Easterbrook (1984).
Rozeff (1982) tests the cost minimization model using Ordinary Least Squares cross sectional regression
and 1000 US firms with data relating to 1981. Transactions costs faced by the firm are measured by past
and forecasted growth rates in revenues and by the firm͛s beta, which represents risk. An agency cost
variable is taken as the natural logarithm of the number of outside shareholders, which measures
ownership dispersion. It is expected to be positively related to the payout ratio for the reason that the
more dispersed is the ownership structure, the more difficult monitoring becomes. An inverse agency
cost variables is the fraction of the firm owned by insiders. It is expected to be negatively related to the
payout ratio, for the reason that by increasing their holdings in the firm, managers align their interests
with that of outside investors. Rozeff (1982) shows the estimated coefficients on the five explanatory
variables to be significant and to bear the signs predicted by the cost minimization model.
Innovations on the Rozeff͛s (1982) model can basically be split into three types, including adding new
variables, improving the empirical technique or focusing on particular types of firms. Llyod, Jahera and
Page (1985) innovate by adding a new variable, namely firm size, and by refining the empirical approach.
The empirical approach follows Rozeff (1982) by employing the Ordinary Least Squares method and data
on 957 US firms for 1984. Nevertheless, innovation comes in an attempt to reduce correlation between
the explanatory variables by regressing the agency variables on the size variable, and using the residuals
obtained in place of the original agency variables. Results indicate that after multicollinearity is properly
controlled for, the cost minimization model is still valid. All the explanatory variables appear significant
and enter the model with the expected signs. Further, the study concludes that size is also an significant
explanatory variable.
Schooley and rarney (1994) also innovate on the Rozeff͛s (1982) model by adding a new variable,
namely the squared of insider holding, and by attempting to improve the technique. In particular they
relax the linearity assumption with regard insider holdings and assess whether the relationship between
this variable and the optimal payout ratio may be more complex than originally assumed. Rozeff (1982)
suggests that the optimal payout ratio should decline monotonically with rises in insider ownership. As
insider ownership increases, insiders͛ interests are more aligned with that of shareholders, hence
agency costs are reduced and the need for the dividend tool to control these costs is lessened. Schooley
and rarney (1994) suggest that at low level of ownership the relationship between dividends and insider
ownership is as predicted by Rozeff (1982). Nevertheless, when the level of insider ownership reaches a
certain level, further increases cause agency costs to start rising and the need for the dividend control
tool becomes necessary. This occurs due to two reasons. First, when high proportion of their wealth is
invested in the firm, insiders become less diversified. They then tend to evaluate projects based on total
risk and may reject projects even when these are justified based on systematic risk. Second, when
insiders hold substantial percentage of voting rights they achieve a sufficient level of control that
diminishes their risk of being replaced. The results of the Ordinary Least Squares regression, using 1980
data of 235 industrial US firms provide support for the cost minimization model. Further, the
relationship between insider ownership and the firm͛s dividend policy appears to confirm to
expectation.
Moh͛d, Perry and Rimbey (1995) innovate on the cost minimization model by adding a number of new
variables, and by using Weighted Least Square methodology and panel data for 341 US firms over 18
years from 1972 to 1989. The aim is to test whether variation in payout ratios across time can be
explained by changes in the agency cost/transaction cost structure. To capture the dynamics in the
dividend process, variables are not aggregated and the previous period͛s dividend payout ratio is added
to the RHS of the model. The study also decomposes beta, the systematic risk, into its components to
assess more directly the separate effects of financial leverage, operating leverage and the intrinsic
business risk. Further, institutional ownership is added as an explanatory variable. As per agency theory,
the presence of institutional investors should reduce payout ratios due to their role in monitoring
managers͛ activities as suggested in Shleifer and Vishny (1986). Nevertheless, if investors consider taxes
on dividends and on capital gains, then the presence of institutional ownership should increase the
firm͛s payout ratio as suggested in Redding (1997). Indeed, results with respect to institutional holdings
indicate support for the tax hypothesis of dividends. The study also provides supports for the dynamic
nature of the dividend process as per which firms adjust their dividend each year, as new information
becomes available. Holder, Langrehr and Hexter (1998) add two new variables to the cost minimization
model. Free cash flow is added as an agency proxy and the firm͛s focus is added to test stakeholder
theory. Stakeholder theory proposes that non-investors that have implicit contracts with the firm, such
as employees, customers, suppliers and others, also influence the firm͛s decisions including its dividend
policy decisions. Particularly, dividend policy can create value for the reason that by reducing its payout
ratio, the firm signals to implicit claimants an increase in its ability to meet implicit claims. Using panel
data for 477 US firms each with eight years of observations from 1983 to 1990, the study provides
support for both the agency model and stakeholder theory.
All the innovations to Rozeff (1982) reviewed above focused on adding new variables to variants of the
cost minimization model. In contrast the innovation in Hansen, Kumar and Shome (1994) is with respect
to the type of firms for which the model is applied, namely the regulated electric utility industry. It is
proposed that the agency theory of dividend should fit particularly well to the behaviour of regulated
firms for two main reasons. First, agency conflicts in regulated firms are predicted to be particularly
severe as they comprise conflicts between shareholders and regulators. Nevertheless, by paying
dividends the regulated firm exposes its managers and its regulators to capital market monitoring, which
in turn contributes to reducing agency costs. Second, it is proposed that the costs associated with
dividend-induced capital monitoring are lower for utilities for the reason that direct flotation costs of
issuing new equity can be passed on, at least in part, to ratepayers. The study begins by comparing the
mean payout ratios of utilities and S&P400 industrial firms over the period 1981-1985 and over the
period 1986-1990. Results are consistent with the prediction that utilities have higher payout rates as in
both periods the averages payout ratio of utilities are significantly greater than that of non-regulated
firms. Further, results of cross sectional Ordinary Least Squares regressions offer support for the
monitoring rationale for dividends in the case of regulated firms. Indeed, it is concluded that the
monitoring rationale for dividends could be the answer to the puzzle of why firms often issue new
equity while at the same time paying large dividends.
The innovation in Hansen, Kumar and Shome (1994) of applying the cost minimization model to a
particular type of firms, is also the approach in Rao and White (1994). Nevertheless, while the former
study applies the model to firms for which the monitoring rationale for dividend is predicted to be
particularly suited, the latter study applies the model to the opposite type of firms. Thus, Rao and White
(1994) apply the cost minimization model to private firms for which the monitoring rationale for
dividend is predicted to be particularly unsuitable. Indeed, it is noted that the motivation to use
dividend as an agency-cost controlling device may be less significant for private firms due to less agency
problems. Moreover, as private firms do not participate in the capital market, the rationale for dividends
as inducing further equity issues leading to capital market monitoring also loses some of its momentum.
Another innovation in Hansen, Kumar and Shome (1994) is that they incorporate taxes into the model,
as it is argued that tax savings considerations may contribute to private firms͛ preference for low payout
policies. This is explained as follows. Owners/managers of private firms receive returns in the form of
either salary, which is a tax deductible business expense, or dividends. There is therefore incentive to
minimize the dividends and to increase the salary component. Although limits are imposed on the
amount of salary that can be paid, owners may still have incentive to minimize dividends due to tax
differentials between dividends and capital gains. Nevertheless, it is noted that if the Internal Revenue
Service suspects that a firm is retaining its earnings for the purpose of avoiding taxes, it may take steps
to impose Accumulated Earnings Tax on that firm. Thus AET is added to the model to proxy for the tax
cost of not paying dividends. The third innovation in Rao and White (1994) is the empirical technique,
which is the limited dependent variable regression as opposed to Ordinary Least Squares. The rationale
for this is as follows. The sample comprises 66 private US firms that had been challenged in court by the
Internal Revenue Service for Accumulated Earnings Tax liability between 1928 and 1988. Nevertheless,
as the Internal Revenue Service is unlikely to challenge firms with high payout ratios, the sample
excludes firms with payout ratios greater than some high latent level. This implies that the dependent
variable of the firms comprised in the sample is not normally distributed but truncated from above, and
Ordinary Least Squares method is inappropriate.
Results in Rao and White (1994) show that the agency cost variables, namely the fraction of shares held
by insiders, and the dispersion of ownership as reflected in the number of shareholders, influence the
payout ratio in the manner predicted. This suggests that the agency cost argument for dividends
appears applicable even for private firms that do not participate in the capital market. It is suggested
that by paying dividends private firms can still induce monitoring by bankers, accountants and tax
authorities. The proxy for the Accumulated Earnings Tax cost is also found to be significant and to enter
the model with the predicted sign. This suggests that tax cost considerations influence the dividend
decisions of private firms. Thus firms that are likely to be challenged and charged by the Internal
Revenue Service for Accumulated Earnings Tax, reduce the probability of facing such costs by increasing
their payouts. Rao and White (1994) demonstrate the relevance of agency considerations to dividend
decisions not merely in the most likely cases as shown in Hansen, Kumar and Shome (1994) for
regulated firms, but rather in the least likely cases such as private firms. Hansen, Kumar and Shome
(1994) contribute to the discussion by emphasizing the use of dividend to control conflicts beyond
shareholders and managers, such as conflicts with regulators. In the same trend, Holder, Langrehr and
Hexter (1998) discuss how dividend can be used to control conflicts relating to non-investor
stakeholders in the firm.
The complexity of agency behaviour, and in particular how insider holdings influences agency costs, is
emphasized in Schooley and rarney (1994), while Moh͛d, Perry and Rimbey (1995) address the dynamic
nature of the agency/transaction cost structure. The latter study also illustrates the significance of tax
considerations in determining the payout ratio of firms as reflected in the positive and significant impact
of institutional investors on payout levels. The significance of incorporating tax into the model is also
picked-up in Rao and White (1994), while the significance of firm size is shown in Holder, Langrehr and
Hexter (1998), Moh͛d, Perry and Rimbey (1995), and Llyod, Jahera and Page (1985). One thread,
nevertheless, common to all the above-mentioned studies is that they provide support for the
monitoring rationale of dividend and for Rozeff͛s (1982) cost minimization model. Nevertheless, as
predicted by tax and transaction cost theories, and indeed as incorporated in the cost minimization
model, using the dividend monitoring device is not costless. It has therefore been suggested by a
number of studies, that the extent to which the dividend-monitoring device is used to control agency
cost should display sensitivity to the availability of alternative mechanisms. Some of the empirical work
in this area is reviewed in the next sub section.
  
     
 
   
     

 
 

  

       



   
Easterbrook (1984) points to two significant implications of the monitoring rationale for dividends. First,
it is noted that dividends must influence the firm͛s financing policies, if the reason that they are paid is
to drive the firm to the capital market. Second, as the dividend-monitoring device is costly, the presence
of alternative mechanisms that limit agency problems, or conditions that force the firm to the capital
market, should reduce the use of the dividend device. The implications of these two points are that the
dividend rationale is applicable only in some cases. Further, in these cases, the dividend and capital
structure decisions are endogenous variables and should be modelled as a pair of simultaneous
equations in a signal model. Noronha, Shome and Morgan (1996) test whether the presence of growth-
induced monitoring or other non-dividend devices that limit agency problems, lessen the monitoring
role of dividends and the simultaneity of dividend and capital structure decisions. For that purpose a
sample of 341 US industrial firms is stratified as per the presence of growth opportunities as measured
by Tobin͛s Q. A firm with Tobin͛s Q value above the sample average is classified as high on growth
opportunities. The sample is then further stratified as per the presence of alternative non-dividend
monitoring mechanisms. A firm is classified as possessing alternative non-dividend monitoring
mechanism if it satisfies two conditions. First, the firm has to have an above average incentive
component in its managerial compensation package, which serves to align managers-shareholder
interests. Second, the firm has to have a single large outside shareholder holding at least 5% of the
firm͛s equity, for the reason that a large outside shareholder serves as an external monitor and a
potential take-over threat.
The stratification procedure, in Noronha, Shome and Morgan (1996), results in two sub-samples. Sample
A consists of 131 firms with high alternative control mechanisms and/or growth-induced capital market
monitoring. Sample r consists of 210 firms with low alternative control mechanisms and low growth
opportunities. The sample data is pooled from the period 1986 to 1988 following a Chow test that fails
to reject the null of stability. The monitoring rationale for dividends is tested by an Ordinary Least
Squares regression of a variant of the cost minimization model, where firm size is taken as a proxy for
transaction costs. Results for group A are weak, as none of the agency cost/transaction cost structure
variables are insignificant. In contrast, results for group r support the cost minimization model as the
coefficients on all the variables bear the expected signs, and all but the coefficient on firm size, are
significant.
In the second part of the study, Noronha, Shome and Morgan (1996) test for simultaneity between
dividend and capital structure decisions. It is predicted that simultaneity should be evident only in cases
where the dividend monitoring rationale applies. Indeed, results of a Three Stage Least Squares tests
show no evidence of simultaneity of dividend and capital structure decisions for group A. The equity
ratio explanatory variable in the payout equation, and the payout variable in the equity ratio equation
are both not significant. In contrast, for group r both, the equity ratio variable in the payout equation
and the payout variable in the equity ratio equation are negative and significant. These results as well as
the results from testing the validity of the cost minimization model, support the partial explanation of
the monitoring rationale for dividends.
More support for the partial explanation of the monitoring rationale for dividends is provided by
Johnson (1995), who studies 129 straight debt offerings by NYSE/AMEX industrial firms between 1977
and 1983. Nevertheless, while in Noronha, Shome and Morgan (1996) alternative agency cost
controlling devices comprise growth opportunities, management incentive schemes and a large outside
shareholder, in Johnson (1995) it is debt. In particular it is shown that dividends and debt are alternative
devices to reduce the agency problem associated with free cash flow (Jensen, 1986). This is for the
reason that both debt and dividend signal a commitment to pay out cash and both may increase visits to
the capital market thus inducing capital market monitoring of management͛s actions.
Indeed, the study finds the average two-day excess return around the debt issue announcement day is
positive and significantly different from zero for low payout firms (0.78 percent). This is interpreted as
implying that the issue is indicative of reduced agency problems. Nevertheless, for high payout firms,
the average excess return on the debt issue announcement is insignificantly different from zero (-0.18
percent). Johnson (1995) further utilizes a Weighted Least Squares methodology to regress the two-day
excess return around the debt issue announcement day on a payout variable. The results from this
procedure also support the notion that dividends and debt are alternative mechanisms for controlling
agency problems. Particularly, the intercept is positive and significant suggesting that the price reaction
to debt issue announcement is generally positive. Nevertheless, the coefficient on the payout variable is
negative and significant suggesting that the reaction to the debt issue announcement is weaker for
dividends paying firms. These effects are stronger when the regression is run on a sub sample of 64 low
growth firms but weaker when run on a sub sample of 65 high growth firms. This is consistent with the
view that the potential for wasting free cash flow is greater when profitable investment opportunities
are low. Thus Johnson (1995) provides further support for the conclusions in Noronha, Shome and
Morgan (1996) regarding the substitutability of growth opportunities and dividend as agency costs
controlling devices.
Johnson (1995) illustrates the significance of debt as an alternative to dividends in controlling agency
costs. Crutchley and Hansen (1989) make the same point and suggest that leverage can achieve these
results for the reason that debt finance reduces equity financing and hence manager-shareholder
conflicts. Crutchley and Hansen (1989) further note that manager-shareholder conflicts may also be
reduced by increasing insider holdings. Nevertheless, the crucial point in the study is the realization that
each of the three agency control devices, namely managerial ownership, leverage and dividends, is
costly. For instance, while increasing management͛s ownership helps to align manger-shareholder
interests, it also increases the proportion of the manager͛s total personal wealth, which is invested in
the firm. As the manager suffers increasing lack of diversification, she will be more risk averse even
when this is not in line with shareholder interests.
To test the agency theory of managerial ownership, leverage and dividends, Crutchley and Hansen
(1989) use 603, US industrial firms for the period 1981 to 1985, and Ordinary Least Squares analysis.
Particularly, each of the three policy decisions is regressed on five firm͛s characteristics that are
hypothesized to influence the levels of the costs associated with each policy. These explanatory
variables comprise firm diversification, earnings volatility, flotation costs, advertising and R&D
expenditure, and firm size. The results support the notion that managers employ a mix of policies
including leverage policy, dividend policy and managerial ownership incentives in an effort to control for
agency costs in the most efficient manner. The precise combination of policies varies across firms and is
determined by firm͛s characteristics.
First Crutchley and Hansen (1989) find that managers of diversified firms bear relatively lower costs in
increasing the percentage of their wealth invested in the firm͛s equity. Thus diversified firms tend to use
more of the managerial ownership device and less of the debt and dividend devices to control agency
costs. Second firms with volatile earnings face higher bankruptcy risk thus managers reduce leverage
and increase dependency on managerial ownership and dividends. Third firms with volatile stock expect
to pay higher underwriting fees when issuing new equity thus they tend to increase the use of
managerial ownership and leverage, but avoid using dividends. Forth, firms with high R&D expenditure
have more freedom to engage in wealth expropriation from both debt and share holders, thus these
firms tend to use less debt and dividends and more managerial ownership. Fifth, large firms face lower
bankruptcy costs and lower flotation costs on the issue of new equity, while managers of these firms
find it more expensive in terms of diversification costs to increase their percentage holdings. Thus large
firms tend to rely more on the debt and dividend policy devices and less on managerial ownership.
Similar to Crutchley and Hansen (1989), Agrawal and Jayaraman (1994) also investigate the
substitutability between leverage, dividends and management ownership in controlling agency costs.
The study utilizes 71 industry-size matched pairs of all equity and levered firms for the year 1981, and an
Ordinary Least Squares regression analysis. Specifically, proxies for dividend policy are regressed on
leverage, managerial ownership, an interaction term, and on two control variables including free cash
flow and growth. Results show the coefficient on the leverage dummy, to be negative and significant,
which is consistent with the prediction that all-equity firms follow a policy of higher payout ratios than
levered firms. Similarly, consistent with the prediction that firms with lower insider ownership adopt
higher payout ratios, the coefficient on this variable is reported as negative and significant. This negative
correlation between dividends and insider ownership is stronger in all-equity firms as observed by the
positive and significant coefficient on the interaction term between leverage and insider ownership.
rathala and Rao (1995) introduce roard composition as a possible agency-cost controlling device. They
investigate the interrelation between roard composition, insider ownership, dividends and leverage as
alternative mechanisms for reducing manager-shareholder conflicts. It is argued that outside directors
on the roard can reduce conflicts due to their independence and due to the need to maintain
reputation in the market for their services. To test this, 261 non-regulated, US firms are used in a cross
sectional Ordinary Least Squares regression of a measure of roard composition on alternative agency-
cost control devices and on a set of control variables. The results from this procedure show that the
alternative agency-cost control devices, including insider holdings, dividends and leverage, have a
negative and significant impact on the fraction of outside directors on the roard. These findings are
consistent with the notion of firms relying on a mix of alternative mechanisms, including roard
composition, to control agency conflicts.
rathala and Rao (1995) note that alternative mechanisms may control different aspects of agency
conflicts and that each mechanism may have other, non-agency-related benefits, associated with its use.
Empirical work appears to confirm the presence of substitutability amongst various mechanisms
including dividends, leverage, managerial ownership and incentive schemes, the presence of a large
shareholder, growth, and outside directors on the roard. In the face of these many alternatives, the
agency related value of dividends is still unclear.
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The empirical literature has recorded systematic variations in dividend behaviour across firms, countries
and time, as well as in the type of dividend paid. Such systematic variations are inconsistent with Miller
and Modigliani͛s (1961) irrelevancy theory, but can be expected in imperfect markets. Indeed, once the
assumptions underling the irrelevancy theory are relaxed, it may be unreasonable to expect that
dividends will have no effect on expected earnings, investment decisions or on the firm͛s risk. If dividend
policy influences any of these factors, then it is also likely to affect value. Precisely how dividend policy
affects value, in the presence of market imperfections, is the subject of various dividend theories, which
together form the dividend controversy. The aim of this chapter was to take stock of the generic
theories that have evolved under market imperfections such as transaction costs, taxes, information
asymmetries and agency conflicts. It was also intended to review the main empirical methodologies and
evidence collected so far, in an endeavor of clarifying where the dividend controversy stands today,
after four decades of debate.
The generic dividend theories comprise the transaction costs theory, the tax hypothesis, the bird in the
hand argument, and the signaling and agency theories. The transaction cost theory of dividends is based
on transaction costs and control considerations that are associated with paying dividends and then
resorting to external finance to fund investments. Also incorporated under this theory are pecking order
considerations, which are based on information asymmetries and which become relevant if dividends
are paid and external finance raised. Thus, the transaction cost theory of dividends basically suggests
that firms should utilize retained earnings to the extent possible before paying out dividends.
The tax hypothesis proposes that government distortions by way of taxes have significant implications
for dividend policy and firm value. Thus the tax hypothesis generally states that due to differences
between taxes on dividends and on capital gains, generous dividends reduce wealth. Accordingly, the
share prices of firms that adopt high payout policies will reflect this tax disadvantage. The underlying
assumption here is that all investors are taxed the same and that dividend income is taxed more heavily
than capital gains. Alternatively, if there exist tax-based clienteles for low and high dividend policies, or
if transaction costs are not too high as to prohibit active trading, then tax effects on prices should
disappear.
The bird in the hand argument is the traditional rationale for generous dividends, and is based on the
idea that dividends reduce risk for the reason that they bring shareholders͛ cash inflows forward. This
argument, nevertheless, is commonly repudiated by the assertion that the risk of the firm comes from
the investments in which it is comprised, not from how the proceeds from these investments are
distributed. A more credible argument in favor of dividends is the signaling theory, which is based on
information asymmetries between managers and outside shareholders. Thus as per the signaling
theory, unexpected dividend changes convey valuable information to market participants that relate to
managers͛ expectations regarding the prospects of the firm. The last dividend theory is the agency
theory of dividends which, like the signaling theory, proposes that dividends are value enhancing.
Nevertheless, while the signaling theory is based on the assumption that managers always act in the
interests of existing shareholders, the agency theory relaxes this assumption and allows for agency
conflicts. The agency theory of dividends is different from the signaling theory in another crucial respect.
Particularly, as per the signaling theory dividends have no value in themselves, but their value is derived
from the information they contain about the firm͛s fundamentals. In contrast, the agency theory of
dividends states that the payment of dividends is in itself valuable for the reason that it controls agency
costs in two ways. First, the payment of dividends reduces the free cash flows under managers͛
discretion. Second, the payment of dividends forces the firm to the capital market inducing external
monitoring of the firm and its management, which is valuable due the free rider problem of collective
monitoring.
The discussion on the theoretical themes that have developed to explain the dividend puzzle was
followed by a review of some of the relevant empirical methodologies and evidence. Event studies
around ex-dividend days are typically used to investigate tax clientele effects. Similarly, the market
reaction to the dividend signal is often investigated by event studies around dividend announcement
dates, while other methodologies comprise comparison and regression analyses. Nevertheless, one
unique approach to understanding dividend policy, whose findings have been central to the dividend
debate is the Lintner͛s (1956) survey of US managers. The main conclusions from this study are that
managers concern themselves primarily with the stability of dividends, believing that the market reacts
favorably to dividend increases and unfavorably to decreases. Furthermore, the level of earnings is the
most significant determinant of the dividend level, and the dividend decision is taken before other
decisions such as investment decisions, which are then adjusted.
Lintner͛s (1956) study is consistent with the signaling rationale for dividends. Nevertheless, evidence
from empirical studies of the signaling hypothesis is mixed. In general it appears that the market reacts
strongly to unexpected dividend changes, and that the reaction is typically in the same direction as the
dividend change. Nevertheless, evidence is weaker on actual changes in performance that follow the
dividend change announcement. Similarly no consensus has been achieved on the effects of taxes,
particularly on whether taxes have permanent or only temporary impact on prices, although the general
conclusion is that taxes enter the dividend decision. The transaction/agency costs structure faced by the
firm appears significant in determining its dividend policy. Nevertheless, there is also evidence of
substitutability amongst dividends and other agency cost control devices such as leverage, managerial
ownership, incentive schemes, investment opportunities and others. Thus the general conclusion is that
after four decades of debate, the jury is still out on the dividend puzzle.
For this matter, further research is required to sustain the spotlight on the dividend puzzle. In particular,
there are four promising research ideas (PRIs), which derive directly from the theoretical and empirical
literature surveyed in this chapter. The first PRI relates to the role of agency theory in explaining
dividend policy for firms operating in emerging markets, where imperfections are the norm rather than
the exception. In these markets agency conflicts and information problems can be expected to loom
strong and the finance gap to be particularly wide. Thus models that incorporate these factors, such as
the cost minimization model reviewed, should describe well the target payout process of firms in
emerging markets. The second PRI is inspired by developments in areas of corporate governance, and
therefore seeks to attain a synergy between corporate governance and the dividend policy puzzle. It
may be that the failure to unravel the dividend puzzle has been amplified by failure to recognize
interaction of the dividend policy practice with other business features. One idea is to bring together the
literature on business groups and firm ownership in order to understand dividend policy, especially in
the case of emerging markets.
The third PRI recognizes that different theories may have the same practical implications thus making
difficult the task of distinguishing amongst them. For instance, both agency theory and signaling theories
predict a positive reaction to dividend increases and negative reaction to decreases. One possible
method of distinguishing between these theories is by exploiting institutional differences across
countries, as in Dewenter, and Warther (1998) with respect to the US and Japan. Furthermore, cross
country comparisons can also assist in establishing fine distinctions between various under-themes
within major theories. For instance, La Porta, Lopez-de-Silanes, Shleifer and Vishny (2000) use cross-
country comparisons to distinguish between two competing agency models of dividends, namely the
outcome and substitute models. Finally, the forth PRI is to use a system of equations instead of the
single equation model of dividends. This idea is discussed in Prasad Green and Murinde (2001), and
acknowledges the possibility that policy choices may be simultaneously determined. An example is
Jensen, Solberg and Zorn (1992), where insider ownership, debt and dividend policies are modeled as a
simultaneous equations system.
"9":<c"ãã

1. Explain the Transaction Cost Theory.

2. What do you mean by ͞The rird in Hand Argument͟?
3. What is Agency Theory of Dividend?
4. Explain permanent earnings, cash flow and risk information hypothesis of dividend.
5. Explain the Rozeff͛s Cost Minimization Model.

¢ã"ãc;



   

 *

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. 

 
 

 
Dividend policy is one of the most intriguing topics in financial research. Even now, economists provide
considerable attention and thought to solving the dividend puzzle, resulting in a large number of
conflicting hypotheses, theories and explanations. Researchers have primarily focused on developed
markets; nevertheless, additional insight into the dividend policy debate can be gained by an
examination of developing countries, which is currently lacking in the literature. Dividend policy in
emerging markets is often different in its nature, characteristics, and efficiency, from that of developed
markets. The purpose of this paper is to identify the factors that influence the dividend policy of firms
listed in GCC countries, while focusing on agency and transaction cost theory.




'
Dividend policy has been the subject of considerable debate since Miller and Modigliani (1961)
illustrated that under certain assumptions, dividends were irrelevant and had no influence on a firm͛s
share price. Since then, financial researchers and practitioners have disagreed with Miller and
Modigliani͛s proposition and have argued that they based their proposition on perfect capital market
assumptions, assumptions that do not exist in the real world. Those in conflict with Miller and
Modigliani͛s ideas introduced competing theories and hypotheses to provide empirical evidence to
illustrate that when the capital market is imperfect, dividends do matter. For instance, the bird in the
hand theory (predating Miller and Modigliani͛s paper) explains that investors prefer dividends (certain)
to retained earnings (less certain): therefore, firms should set a large dividend payout ratio to maximise
firm share price (Gordon, 1956; Lintner, 1956; Fisher, 1961; Walter, 1963; rrigham and Gordon, 1968).
In the early 1970s and 1980s, several studies introduced tax preference theory (rrennan, 1970; Elton
and Gruber, 1970; Litzenberger and Ramaswamy, 1979; Litzenberger and Ramaswamy, 1982; Kalay,
1982; John and Williams, 1985; Poterba and Summers, 1984; Miller and Rock, 1985; Ambarish et al.,
1987). This theory suggests that dividends are subject to a higher tax cut than capital gains. This theory
further argues that dividends are taxed directly, while capital gains tax is not realised until a stock is
sold. Therefore, for tax-related reasons, investors prefer the retention of a firm͛s profit over the
distribution of cash dividends. The advantage of capital gains treatment, nevertheless, may lead
investors to favour a low dividend payout, as opposed to a high payout. In the early 1980s, signalling
theory was analysed. It revealed that information asymmetry between managers and outside
shareholders allows managers to use dividends as a tool to signal private information about a firm͛s
performance to outsiders (Aharony and Swary, 1980; Asquith and Mullins, 1986; Kalay and Loewenstein,
1985; Healy and Palepu, 1988).
Another explanation for dividend policy is based on the transaction cost and residual theory. This theory
indicates that firms incurring large transaction costs, will be required to reduce dividend payouts to
avoid the costs of external financing (Mueller, 1967; Higgins, 1972; Crutchley and Hansen, 1989; Alli et
al., 1993; Holder et al., 1998). A different explanation, which received little consideration prior to the
1980s, relates dividend policy to the effect of agency costs (La Porta et al., 2000). Agency costs, in this
case, are costs incurred in monitoring company management to prevent inappropriate behaviour. Large
dividend payouts reduce internal cash flows, forcing managers to seek external financing, and thereby,
making them liable to capital suppliers, thus, reducing agency costs (Rozeff, 1982; Easterbrook, 1984;
Lloyd, 1985; Crutchley and Hansen, 1989; Dempsey and Laber, 1992; Alli et al., 1993; Moh͛d et al., 1995;
Glen et al., 1995; Holder et al., 1998; Saxena, 1999). Dividend policy has been analysed for many
decades, but no universally accepted explanation for companies͛ observed dividend behaviour has been
established. rrealey and Myers (2005) described dividend policy as one of the top ten most difficult
unsolved problems in financial economics. This description is consistent with rlack (1976) who stated
that ͞The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that don͛t
fit together͟. What might be significant to mention, is that researchers have primarily focused on
developed markets, while little attention has been paid to dividend policy in emerging markets. As a
result, this field is not well established in the financial literature. Dividend policy in emerging markets is
often very different in its nature, characteristics, and efficiency, from that of developed markets. In
particular, the case of the GCC countries has some interesting characteristics that make the study
appropriate in terms of policy recommendations for the GCC countries and other emerging countries.
First, the GCC environment is unique in that taxes are not paid on dividends, or capital gains.
This leads investors, in these particular countries, to favour a large dividend payout. Second, the stock
exchanges in these countries are more volatile and entail a certain degree of information asymmetry, in
addition to an expectation that high agency costs will be incurred. Third, governments own a significant
proportion of shares in the GCC listed firms, especially large-sized firms. Therefore, government
participation might create a complex setting of agency theory, whereby government comprisement may
duplicate the agency problem and, at the same time, served managing. As a result of the GCC͛s
characteristics, there is considerable interest in identifying dividend policy determinants for these
companies, especially the validity of the agency explanation in the listed GCC firms. Thus, this paper
continues the debate over dividends in the emerging market area, by presenting new evidence from
GCC countries. Therefore, it may be that additional insight into the dividend policy debate can be gained
for the case of developing countries.
60h
  


 

   
 #   
The previous section reviewed the framework of dividend policy and discussed several studies that
tested dividend policy in emerging markets. This section formulates seven hypotheses to further
examine the factors, which may affect corporate dividend policy. This section also explains the
appropriate proxy variables used to measure the factors affecting dividend payouts.
  # 
Ownership Structure: In a modern corporate environment where there is a large separation between
ownership and management, conflicts of interest can arise between managers, inside owners
(controlling shareholders), and outside shareholders, such as minority shareholders. Referring to this
problem, Jensen and Meckling (1976) describe the firm as a nexus of contracting relationships among
individuals. Nevertheless, when the manager makes a decision, it tends to be in favour of the agent,
rather than of the firm. La Porta et al. (2000) illustrated that managers may take advantage of their
authority to benefit themselves by diverting firm assets to themselves through theft, excessive salaries
or sales of assets at favourable prices to themselves. Accordingly, the ownership structure in large firms
may influence dividends and other financial policies (Desmetz, 1983; Desmetz and Lehn, 1985; Shleifer
and Vishny, 1986; Morck et al., 1988; Schooley and rarney, 1994; Fluck, 1999; La Porta 2000; Gugler and
Yurtoglu, 2003). Several studies have suggested that dividend payouts can play a useful role in reducing
the conflict between inside and outside owners. When insider owners pay cash dividends, they return
corporate earnings to investors and can no longer use these earnings to benefit themselves (La Porta et
al., 2000). Nevertheless, the percentage of earnings that can be used as dividends depends upon the
ownership structure of the firm.
Glen et al. (1995), Gul (1999a), Naser et al. (2004) and Al-Malkawi (2007) specified that in emerging
markets, government ownership is a major determinant of the dividend decision-making process. Gul
(1999a) suggested a positive association between government ownership and dividends, arguing that
firms with high government ownership find it less difficult to finance investment projects, and hence,
can afford to distribute more dividends. Conversely, firms with lower (or no) government ownership
face difficulties in raising money, and instead consequently rely on retained earnings for investments,
thereby paying small dividends. Glen et al. (1995) argued that investors need to be protected in
countries with poor legal systems. In addition, since governments are powerful investors, they should
act as a safeguard for the minority shareholders by monitoring the insider shareholders and forcing
them to disgorge cash. Naser et al. (2004) added that in an emerging market, where legal protection is
limited, governments have a strong desire to build up firm reputations and avoid the exploitation of
minority shareholders by paying them large dividends. They further asserted that the need for such a
reputation has significant effects on young stock exchanges where there is no history of the good
treatment of minority outside shareholders. In addition, this need is greater when there is high
uncertainty about the future cash flow of firms.
In a recent study, Al-Malkawi (2007) found that, among large shareholders, the government is one of
the most influential shareholders in affecting the dividend policy of firms listed on the Amman Stock
Exchange. He explained that the government acted on behalf of the citizens, who did not control the
firm directly.
Therefore, in such firms, ͞a double principal-agent͟ conflict existed. This conflict may occur between
citizens and government representatives, who might not act in the citizens͛ best interests and between
government representatives and other managers. The solution to this problem is a larger payment of
dividends, which reduces the cash flow available to managers, thus, reducing the agency problems of
the firm. This explanation concurs with the findings of Gugler (2003), who examined the dividend
policies of Australian firms. Considering all previously discussed arguments, the following hypothesis can
be formulated:
#&  
   
   

    

    
In which the percentage of shares held by the government can be used as an indicator of the firm
ownership structure.
h
 h'
The percentage of shares owned by different types of shareholders may not be the sole determinant of
the dividend-agency relationship; the free cash flow may also be significant. Jensen (1986) defined free
cash flow as the cash flow in excess of the funds required for all projects with a positive net present
value (NPV). He demonstrated that as the free cash flow increases, it raises the agency conflict between
the interests of managerial and outside shareholders, leading to a decrease in the performance of the
company. While shareholders desire for their managers to maximise the value of their shares, the
managers may have a different interest and prefer to derive benefits for themselves. Jensen's free cash
flow hypothesis has been supported by subsequent studies by Jensen et al. (1992) and Smith and Watts
(1992). La Porta et al. (2000) added that when a firm has a free cash flow, its managers will engage in
wasteful practices, even when the protection for inventors improves. A number of studies have
suggested that firms with a greater ͞free cash flow͟ need to pay more dividends to reduce the agency
costs of the free cash flow (Jensen, 1986; Holder et al., 1998; La Porta et al., 2000; and Mollah et al.,
2002). rased on the findings of the above studies, it can be speculated that there is a positive
relationship between the free cash flow and the dividend payout ratio. Therefore, the second
hypothesis becomes:
#'  
   
   

        

The free cash flow to total asset ratio can be used as a proxy for the free cash flow variable. Eddy and
Seifert (1988), Jensen et al. (1992), Redding (1997), and Fama and French (2000) indicated that large
firms distribute a higher amount of their net profits as cash dividends, than do small firms. Several
studies have tested the impact of firm size on the dividend-agency relationship. Lloyd et al. (1985) were
among the first to modify Rozeff's model by adding ͞firm size͟ as an additional variable. They considered
it an significant explanatory variable, as large companies are more likely to increase their dividend
payouts to decrease agency costs. Their findings support Jensen and Meckling͛s (1976) argument, that
agency costs are associated with firm size. They were of the view that for large firms, widely spread
ownership has a greater bargaining control, which, in turn, increases agency costs. Furthermore, Sawicki
(2005) illustrated that dividend payouts can help to indirectly monitor the performance of managers in
large firms. That is, in large firms, information asymmetry increases due to ownership dispersion,
decreasing the shareholders͛ ability to monitor the internal and external activities of the firm, resulting
in the inefficient control by management. Paying large dividends can be a solution for such a problem
for the reason that large dividends lead to an increase in the need for external financing, and the need
for external financing leads to an increase in the monitoring of large firms, for the reason that of the
existence of creditors.
Other studies related the positive association between dividends and firm size to transaction costs. For
instance, Holder et al. (1998) revealed that larger firms have better access to capital markets and find it
easier to raise funds at lower costs, allowing them to pay higher dividends to shareholders. This
demonstrates a positive association between dividend payouts and firm size. The positive relationship
between dividend payout policy and firm size is also supported by a growing number of other studies
(Eddy and Seifert, 1988; Jensen et al., 1992; Redding, 1997; Holder et al., 1998; Fama and French, 2000;
Manos, 2002; Mollah 2002; Travlos et al., 2002; Al-Malkawi, 2007). Therefore, the hypothesis in regard
to firm size is formulated as:
#(  
   
   

       %  R 

A review of the literature revealed several explanations for the relationship between growth
opportunities and dividend policy. One explanation was that a firm tended to use internal funding
sources to finance investment projects if it had large growth opportunities and large investment
projects. Such a firm chooses to cut, or pay fewer dividends, to reduce its dependence on costly external
financing. On the other hand, firms with slow growth and fewer investment opportunities pay higher
dividends to prevent managers from over-investing company cash. As such, a dividend here would play
an incentive role, by removing resources from the firm and decreasing the agency costs of free cash
flows (Jensen, 1986; Lang and Litzenberger, 1989; Al-Malkawi, 2007). Consequently, dividends were
found to be higher in firms with slow growth opportunities, compared to firms with high-growth
opportunities, as firms with high-growth opportunities have lower free cash flows (Rozeff, 1982; Lloyd et
al., 1985; Jensen et al., 1992; Dempsey and Laber, 1992; Alli et al., 1993; Moh'd et al., 1995; Holder et
al., 1998).
A number of other studies compared investment opportunity ratios to distinguish growth from non-
growth firms (Murrali and Welch, 1989; Titman and Wessels, 1988; Gavers and Gavers, 1993; Moh'd et
al., 1995). These studies revealed that growth firms, as compared to non-growth firms, exhibited a lower
debt to reduce their dependence on external financing, which is costly. This explanation is consistent
with Myers (1984), who stated that investment policy can be substituted for dividend payouts,
therefore, reducing the agency problem, for the reason that it reduces the free cash flow. La Porta et al.
(2000) investigated countries with high legal protection and revealed that fast-growth firms paid lower
dividends, as the shareholders were legally protected, allowing them to wait to receive their dividends
when the investment opportunities were good. On the other hand, in countries with low legal
protection for shareholders, firms kept the dividend payout high, to develop and maintain a strong
reputation, even when they had better investment opportunities.
Several studies found that the sales/revenues growth rate was commonly used as a proxy variable for
growth opportunities (Rozeff, 1982; Lloyd et al., 1985; Jensen et al, 1992; Alli et al., 1993; Moh͛d et al.,
1995; Holder et al., 1998; Chen et al., 1999;, Saxsena, 1999; Manos, 2002; Travlos, 2002). To retain
comparability, this study also used this proxy for growth opportunities and tested the hypothesis that:
#$  
   
   

 


    
   

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A growing number of studies have found that the level of financial leverage negatively affects dividend
policy ( Jensen et al., 1992; Agrawal and Jayaraman, 1994; Crutchley and Hansen, 1989; Faccio et al.,
2001; Gugler and Yurtoglu, 2003; Al-Malkawi, 2005). Their studies inferred that highly levered firms look
forward to maintaining their internal cash flow to fulfil duties, instead of distributing available cash to
shareholders and protect their creditors. Nevertheless, Mollah et al. (2001) examined an emerging
market and found a direct relationship between financial leverage and debt-burden level that increases
transaction costs. Thus, firms with high leverage ratios have high transaction costs, and are in a weak
position to pay higher dividends to avoid the cost of external financing. To analyze the extent to which
debt can affect dividend payouts, this study employed the financial leverage ratio, or ratio of liabilities
(total short-term and long-term debt) to total shareholders͛ equity. rased on the above arguments, the
following hypothesis was formulated for further investigation:
#)  
   
  


      




r
 

Several studies have been used to measure the beta value, as a proxy for the systematic risk where beta
measures the stock's volatility in relation to the market (Rozeff, 1982; Lloyd et al., 1985; Alli et al., 1993;
Moh͛d et al., 1995; Casey and Dickens, 2000).
In addition, it has been argued that high-risk firms tend to have a higher volatility in their cash flows,
than low-risk firms. Consequently, the external financing requirement of such firms will increase, driving
them to reduce the dividend payout to avoid costly external financing (Higgins, 1972; McCabe, 1979;
Rozeff, 1982; Chang and Rahee, 1990; Chen and Steiner, 1999). Jensen et al. (1992) contended that
greater systematic risk increased the uncertainty of the direct relationship between current and
expected future profits. Hence, firms avoid commitment to pay large dividends, as the uncertainty about
earnings increases. Moh'd et al. (1995) also reported an inverse relationship between the dividend ratio
and intrinsic business risk, proxied by beta. They indicated that firms with unstable earnings paid lower
dividends, in an attempt to keep the dividend payout stable and to avoid the high cost of external
financing. In contrast, Mollah (2002) found that firms listed on the Dhaka Stock Exchange paid a large
dividend, even though the beta for their stock was high. He then argued that in an emerging stock
exchange, the dividend might not be the most appropriate tool to convey correct information about
transaction costs to the market. This study uses beta as a common proxy for firm business risk, which
represents a firm͛s operating and financial risk (Rozeff, 1982; Loyed et al., 1985; Jensen et al., 1992; Alli
et al., 1993; Moh͛d et al., 1995; Holder et al., 1998; Chen et al., 1999; Saxsena, 1999; Manos, 2002).
rased on the previous discussion, the following hypothesis was formulated:
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The financial literature documents that a firm͛s profitability is a significant and positive explanatory
variable of dividend policy (Jensen et al., 1992; Han et al., 1999; Fama and French, 2000). Nevertheless,
there is a significant difference between dividend policies in developed and developing countries. This
difference has been reported by Glen et al. (1995), showing that dividend payout rates in developing
countries are approximately two-thirds of those in developed countries. Moreover, emerging market
corporations do not follow a stable dividend policy; dividend payment for a given year is based on firm
profitability for the same year. La Porta et al. (2000) compared countries that had strong legal
protection for shareholders with those that had poor shareholder legal protection, and related that to
countries with inferior quality shareholder legal protection. Their conclusion was that shareholders will
take whatever cash dividend they can get from firm profits, where a dividend is perceived as unstable.
Wang et al. (2002) compared the dividend policy of Chinese and UK listed companies, and found that
the former tended to vote for a higher dividend payout ratio, than the latter. Moreover, UK companies
had a clear dividend policy in which annual dividend increases and all companies paid a cash dividend. In
contrast, Chinese companies had unstable dividend payments and their dividend ratios were heavily
based on firm earnings for the same year, not on any other factor. The latter finding was consistent with
that of Adaoğlu (2000), who stated that the main determinant in the amount of cash dividends in the
Istanbul Stock Exchange was earnings for the same year. Any variability in the earnings of corporations
was directly reflected in the cash dividend level. A similar result was reported by Pandey (2001) for
Malaysian firms. Al-Malkawi (2007) identified the profitability ratio as the key determinant of the
corporate dividend policy in Jordan.
As a proxy, this study measured firm profitability by the return on equity (ROE) (Aivazian et al., 2003, ap
Gwilym et al., 2004). The following hypothesis was formulated to test the ROE:
 #+  
   
   

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To investigate the seven hypotheses created in this study associated with the impact of agency and
transaction costs on dividend payment ratios of GCC listed companies, this study undertook an empirical
testing of a model with the following framework:
DIV M f (GOV, FCF, SIZE, GROW, LEV, rETA, PROF)
Where: the dividend payout ratio (DIV) is the dependent variable that is defined as:
DIV M (cash dividends/net profits)*100
The dividend payout ratio indicates the percentage of profits distributed by the company among
shareholders out of the net profits, or what remains after subtracting all costs (e.g., depreciation,
interest, and taxes) from a company͛s revenues. Most of the previous studies that investigated the
impact of agency theory and transaction cost theory employed dividend payout ratios as a determinant
of dividend in lieu of dividend per share and dividend yield (Rozeff, 1982; Lloyd,1985; Jensen et al.,
1992; Dempsey and Laber, 1992; Alli et al., 1993; Moh͛d et al., 1995; Holder et al., 1998; Chen et al.,
1999; Saxena, 1999; Mollah et al., 2002; Manos, 2002; Travlos, 2002). The dividend payout ratio is also
used in this research, rather than dividend per share and dividend yield, for two reasons. Firstly, the
dividend payout ratio takes into consideration both dividend payout and dividend retention. Such a
consideration is essential, for the reason that the hypotheses to be examined in this study are
concerned with the relationship between the dividend payout and the amount of cash retained in the
business, as well as how this may reduce agency costs and encourage future investment. Secondly,
dividend per share and dividend yield were considered unsuitable, for the reason that neither takes into
account the dividend paid in relation to the income level. It may also be true that the dividend yield
model is considered a measure of firm value and a return to shareholders, and therefore, it may not
necessarily be related to agency theory.
To investigate whether the dividend payout ratio is affected by ownership structure, the model uses the
percentage of shares owned by the government (GOV), as has been used in several existing studies (Gul,
1999a; Gugler, 2003). Free cash flow (FCF) is a measure of how much cash a company has for ongoing
activities and growth after paying its bills. FCF is calculated as:
FCF M (net profit ʹ changes in fixed assets- changes in net working capital)/total assets
Firm size (SIZE) is measured as a natural logarithm of market capitalisation. This is due to the fact that
large firms will pay large dividends to reduce agency costs (Ghosh and Woolridge, 1988; Eddy and
Seifert, 1988; Redding, 1997). Growth rate (GROW) is measured as the growth rate of sales (Rozeff,
1982; Lloyd et al., 1985; Jensen et al., 1992; Alli et al., 1993; Moh͛d et al., 1995; Holder et al., 1998; Chen
et al., 1999; Sexsena, 1999; Manos, 2002; Travlos, 2002).
Leverage ratio (LEV) is measured as the debt to equity ratio as shown below:
LEV M total debt/shareholders͛ equity
Debt to equity ratio has also been used as a proxy by a number of existing studies (Jensen et al., 1992;
Mollah, 2001; and Al-Malkawi, 2005).
rusiness risk is denoted by rETA, a mathematical measure of the sensitivity of the rates of return on a
given stock, compared with the rates of return on the market as a whole. It is used as a proxy for
business risk (Rozeff, 1982; Lloyd et al., 1985; Jensen et al., 1992; Alli et al., 1993; Moh͛d et al., 1995;
Holder et al., 1998; Chen et al., 1999; Sexsena, 1999; Manos, 2002). Profitability (PROF) is the ratio of
net profits to the amount of money that shareholders have put into the company. ROE has been used in
several studies as a proxy for firm profitability (Aivazian et al., 2003, ap Gwilym et al., 2004.) and is
calculated as follows:
*hJ(

> 
 
@ %
)K55
This creates the assumption that the dividend ratio per year is based on firm earnings for the same year.
10
In order to test the seven hypotheses related to dividend policies of the firms listed on the GCC
countries͛ stock exchanges, the factors representing the characteristics of the firms need to be
collected. As discussed previously, the dependent variable of the proposed dividend policy model is the
annual dividend ratio paid by a firm, and the explanatory variables are percentages of shares of the firm
held by the government, free cash flow, firm size (i.e., market capitalisation), firm growth rate, leverage
ratio, business risk and firm profitability. The primary idea was to test the dividend policies of the firms
listed on the GCC stock exchanges. The intention was to assemble a large sample (cross-sectional and
time-series data) to obtain a good result, collecting data of the above factors for both financial and non-
financial firms, for as many years as possible. At the same time, it was essential that the time period in
which the factors were observed be the same for all firms. Due to limited information on financial firms,
and the problem of missing data, it was not possible to collect the required data related to financial
firms for the same time period. For similar reasons, the required data for non-financial firms were only
available for the five years from 1999 to 2003. Although 245 non-financial firms were listed on the stock
exchanges of GCC countries, the required data were available for 191 nonfinancial firms from 1999 to
2003.
Table 1 shows the total number of non-financial firms listed on each stock exchange of GCC countries.
This table also reveals the number of firms for which the required data were available. It can be seen
that the Muscat Stock Exchange (MSE) had the highest number of non-financial firms (i.e., 75 firms),
while the Doha Stock Exchange (DSE) had the lowest number of non-financial firms (i.e., 10 firms) for
which the required data were available. Table 1 also illustrates that data were available for only 53% of
the firms listed on the DSE. 9 out of 19 firms did not publish the required data prior to 2003, and
therefore, these firms were excluded from the sample.

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Kuwait Stock Exchange (Kuwait) 59 37 63%
Saudi Arabia Stock Exchange (Saudi Arabia) 62 57 92%
Muscat Stock Exchange (Oman) 92 75 82%
Doha Stock Exchange (Qatar) 19 10 53%
rahrain Stock Exchange (rahrain) 13 12 92%
 431 2 7F=

roth the dividend payout ratio and the factors affecting the dividends for 191 nonfinancial firms from
1999 to 2003 were collected. The primary source of these data was the 2004 Gulf Investment Guide
(GIG) (Zughaibi and Kabbani institution), used to obtain the majority of the data. In addition, the
directories of the national stock exchanges for each state were obtained to provide data that were not
available in the Gulf Investment. Nevertheless, it was difficult to obtain data on government ownership
and business risk (rETA). Such data were obtained from a Saudi financial consulting firm, Zughaibi and
Kabbani (www.zkfc.com). Government ownership data for Kuwait were gathered from the daily national
newspapers from 1999 to 2003. Government ownership data for Qatar were obtained from an
unpublished report supplied by the Doha Stock Exchange. The data on business risk for all firms, listed in
the GCC stock exchanges, were also collected from Zughaibi and Kabbani.
80 " $
  

Most existing studies employed a linear regression model, such as a multiple regression, random effects
and fixed effects linear model, to investigate dividend payout ratios. In such models, it is assumed that
the values of all dependent and explanatory variables are treated as known for the entire sample.
Nevertheless, there are some cases, in real-life, where the sample is limited by truncation or censoring.
Censoring of a sample only occurs when the explanatory variables are observed for the entire sample,
but there is limited information about the response variable for a portion of the sample (Long, 1997). In
other words, the response variable is not observed for the entire range of the sample. For instance,
many of the non-financial firms in the GCC stock exchange do not pay dividends (the response variable
of the dividend policy model) to their shareholders (Table 2). Therefore, the dividend payout ratios by
these firms are not observed, even though the characteristics of the firms (the explanatory variables of
the model) are observed for all firms. Truncation limits the sample more severely, than censoring by
excluding the observations based on a threshold of the dependent variable. An example of a truncation
sample, in our case, would be one that excluded from the sample, those firms that do not pay dividends.
It is worth noting that censoring does not change the sample, but truncation does.
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rahrain 12 0 1 11
Saudi Arabia 57 18 20 19
Kuwait 37 2 24 11
Muscat 75 36 24 15
Doha 10 1 2 7
Total 191 57 71 63
Percentage 100% 30% 37% 33%
The firms in our sample were divided into two categories: (1) firms about whom the information on the
explanatory variables, such as firms͛ characteristics (e.g., government ownership, and free cash flow), as
well as the response variables, such as the dividend payout ratio, is available, (2) firms about whom only
the information on the explanatory variables is available. Therefore, our sample is a censored sample.
The appropriate model for such a censored sample is the Tobit model (Tobin, 1958).
The structural equation of the standard Tobit model is:

     h
 (1)
Where:   is the latent dependent variable observed for values greater than 0 and censored for values
less than, or equal to, 0. xi is the vector of the explanatory variable observed for all cases, ɴ is the vector
of coefficients to be estimated, and  is the error term which is assumed to be independently normally
distributed, that is,  ~ `(2,ʍ2). The censored variable, observed over the entire range, is defined by the
following measurement equation:

  _

 
(2)

  
Estimation of the structural equation by OLS is conducted with the censored sample by taking  M 2
when  à , or the truncated sample (that is, the sample with only y > 0), gives inconsistent estimates,
that is, it underestimates the intercept and overestimates the slope, or vice versa (Long 1997; Gujarati,
2003; Woolbridge, 2002; Hsiao, 2002). These studies have suggested the use of the Tobit model
presented below:
Substituting equation (1) in (2) results in:
  h

  _

 
(3)

  
Notice that the observed 0͛s on the dependent variable can mean either a ͞true͟ 0 or censored data
(that is, cannot be observed). At least some of the observations in a sample must be censored data,
otherwise  would always equal   and the true model would be a linear model, rather than a Tobit
model. The use of OLS estimation in the presence of censoring has been found to result in inconsistent
estimates. The suitable estimation method, therefore, is the Maximum Likelihood (ML) estimator, as
such estimates are consistent and asymptotically normal (Greene, 2003, Long 1997). This being the case,
the observations were divided into two groups: (1) uncensored observations in which ML behaves the
same way as the linear regression model, (2) censored observations where the specific value of   is not
known, but the probability of being censored is used. As per Long (1997), the log-likelihood function for
both censored and uncensored observations is given by:
 h h
  h       Þ #  
   
Þ  |     (4)
   
Where: ʔ(.) and Ɍ(.) represent the probability density function (pdf) and cumulative density function
(cdf) of the standard normal distribution, all other terms in this model have been defined previously.
The standard Tobit model may not be appropriate for the modeling of censored panel data, due to the
presence of unobserved heterogeneity. Therefore, the unobserved effects (fixed and random) need to
be taken into consideration. This resulted in two types of unobserved effects in Tobit models: (1) fixed,
and (2) random. The literature suggests that the estimation of a fixed effects Tobit model is complex.
This is for the reason that, at the present time, there is no feasible estimator for a fixed effects Tobit
model (STATA, 2000). Therefore, the fixed effects Tobit model is not considered in this study. The
random effects Tobit model is presented as follows (Long, 1997):
 h


 
  _

  
(5)

  
Where: 9 is the unobserved firm-specific effect assumed to be uncorrelated with ! and independently
and identically distributed with a zero mean and constant variance, that is, ɲi ~ N(0, ʍ2 ). The ML
estimator is used to estimate the models parameters.
70   

 
Table 3 presents the descriptive statistics for the variables, related to firms͛ characteristics, comprised in
the models to examine the dividend policy of non-financial firms listed on the stock exchanges of GCC
countries for 1999 to 2003. The mean of the dividend payout ratio of the 191 non-financial firms
indicates that the firms distributed an average of 43% of their net profits as dividends. The standard
deviation of the dividend payout ratio was 59.8, suggesting that the dividend payout ratio was highly
dispersed. It is noticeable that the Q2 of the dividend payout ratio paid by the firms, where the
government owned a proportion of the shares, was higher (45%) than that of all firms (7%). This is
largely due to the fact that a large proportion of firms did not pay dividends, either consistently, or for
some of the years. For instance, it was found that 30% of the firms (i.e., 57 firms) did not pay a dividend
during the study period and 37% of the firms (i.e., 71 firms) paid a dividend for some years, but did not
pay a dividend for all years. The third quartile, Q3, (i.e., 75th percentile) of the dividend payout ratio is
77.6, implying that 25% of firms paid dividend above 77.6%.
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Dividend ratio 42.858 48.526 59.811 59.019 0.00 0.00 7.00 45.00 77.60 79.20
(DIV)
Government 10.098 18.358 17.512 20.152 0.00 3.00 1.00 8.00 10.22 30.00
ownership
(GOV)
Free Cash 0.003 0.019 0.261 0.247 ʹ0.10 ʹ0.09 0.02 0.03 0.12 0.14
Flow (FCF
Market 629179 981619 3810788 5102016 9984 6669 53269 26975 210600 210956
Capitalisation
(MC)$000
Growth Rate 0.428 0.515 2.722 3.027 ʹ0.02 ʹ0.01 0.05 0.05 0.20 0.19
(GROW)
Firm Leverage 204.875 108.420 2714.892 171.528 17.30 15.10 49.90 45.20 129.00 133.00
(LEV)
rusiness Risk 0.394 0.333 0.474 0.475 0.01 0.01 0.28 17.00 0.72 0.57
(rETA)
Firm 8.649 9.744 12.558 11.068 0.00 0.00 5.50 7.30 13.80 15.00
Profitability
(PROF)
Key:
ALL M Data for all firms
GS M Data from the firms where the government owned a proportion of shares
Multicollinearity between explanatory variables may result in the wrong signs, or implausible
magnitudes, in the estimated model coefficients, and the bias of the standard errors of the coefficients.
To avoid this problem, the Variance Inflation Factor (VIF) test was used. The results of this test are
presented in Table 4. The mean VIF was 1.06, which is much lower than the threshold of 10. The VIF for
individual variables was also very low. This indicates that the explanatory variables comprised in the
model were not substantially correlated with each other.
$39

  
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Firm Size (MC) 1.09 0.9186
Government ownership (GOV) 1.09 0.9196
Firm profitability (PROF) 1.08 0.9271
Free cash flow (FCF) 1.08 0.9302
rusiness Risk (rETA) 1.05 0.9519
Growth Rate (GROW) 1.01 0.9949
Firm Leverage (LEV) 1.00 0.9976
Mean VIF 1.06
To further test whether the explanatory variables were correlated, a pair-wise correlation matrix among
the explanatory variables was estimated. The results are illustrated in Table 5, where it can be seen that
the correlation coefficients were low (all < 0.300), suggesting that there was no multicollinearity
problem among these variables.
$1


 

     



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Variables GOV FCF MC GROW LEV rETA PROF
Government 1.0000
ownership
(GOV)
Free cash 0.1006 1.0000
 flow (FCF)
Firm size 0.2516 0.0229 1.0000
(MC)
Growth rate ʹ0.0112 ʹ0.0346 ʹ0.0204 1.0000
(GROW)
Firm ʹ0.0308 ʹ0.0355 ʹ0.0071 0.0084 1.0000
Leverage
(LEV)
rusiness 0.0785 0.1135 0.1511 ʹ0.0616 ʹ0.0091 1.0000
risk (rETA)
Firm 0.1089 0.2367 0.0202 0.0046 ʹ0.0297 0.1239 1.0000
profitability
(PROF)
Since the dataset is a time-series cross-sectional dataset, the random effects (RE) Tobit model was used,
instead of the standard Tobit model. The estimation results for the random effects Tobit model are
presented in Table 6. The model parameters were estimated using the maximum likelihood estimation
(MLE) method. As can be seen from Table 6, the statistically significant variables at the 95% confidence
level are government ownership, firm size, firm leverage and firm profitability. The insignificant variables
are free cash flow, growth rate and business risk. Since the variables of free cash flow, growth rate, and
business risk were not significant, H3, H4, and H6 could not be supported by the data from the 191
nonfinancial firms considered in this study. The significant variables are discussed in more detail below.
$8" 

 
  
 
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Explanatory Coeff. t-stat Coeff. t-stat
Variables
Government 0.9071 4.96 0.7853 4.00
ownership (GOV)
Free cash Flow ʹ1.1757 ʹ0.09 1.3283 0.11
(FCF)
Ln(Firm size (MC) 10.5845 4.96 11.3535 3.79
in US$)
Growth Rate ʹ0.8066 ʹ0.65 ʹ0.7939 ʹ0.62
(GROW)
Firm Leverage ʹ0.0705 ʹ2.7 ʹ0.0568 ʹ2.15
(LEV)
rusiness risk ʹ9.7570 ʹ1.21 ʹ8.6363 ʹ1.03
(rETA)
Firm profitability 1.0668 4.16 0.9813 3.68
(ROE)
Country-specific
dummies
Saudi Arabia ʹ ʹ
(Reference)
rahrain 45.1264 2.92
Kuwait 28.6671 2.47
Oman ʹ1.4781 ʹ0.10
Qatar 15.6187 0.97
Constant ʹ109.8740 ʹ4.71 ʹ130.5485 ʹ3.42
Descriptive
Statistics
Wald statistic 110.7800 131.6200
P-value>Wald 0.0000 0.0000
statistic
Observations 929 929
Left-censored 460 460
observations
Uncensored 469 469
observations
Log-likelihood ʹ3073.3784 ʹ3063.6868
function
Akaike 6162.7568 6143.3736
Information
criterion (AIC)
As can be seen, two types of models were estimated: (1) the RE Tobit model, estimated without
country-specific dummies (Model A), and (2) the RE Tobit model, estimated with country-specific
dummies (Model r). The dummy variable for Saudi Arabia was taken as a reference, when the other four
dummy variables (rahrain, Kuwait, Oman, and Qatar) were estimated. Even though both models
provided similar results, in terms of their significant variables, the value of the log likelihood function
was higher in Model r, suggesting that it was superior to Model A. Nevertheless, the number of
parameters were different in these two models. Therefore, the Akaike Information Criterion (AIC) was
used to control for parameters, while comparing the goodness-of-fits for these models. The smaller the
value of the AIC, the better the result. AIC for Model A was 6162.76 and for Model r was 6143.37,
suggesting that Model r is superior to Model A. It was also noticed that the values of the coefficients in
Model r were smaller than those of Model A, for some variables. This is not surprising, as the country
specific dummies in Model r will tend to offset some of the effects of the explanatory variables.
The RE Tobit model, with country-specific dummies, were also estimated after removing the outliers
found in the sample data associated with the GCC stock exchanges. Even though the sets of significant
and insignificant variables of this model were the same as the model with the outliers comprised, the
values of the parameters were different (Table 7). Moreover, the log likelihood value of the RE Tobit
model, after removing the outliers, was higher than that of the model before removing the outliers.
Nevertheless, the number of observations between these models was different.
The rayesian Information Criterion (rIC) was used to control for the number of observations, while
comparing the goodness-of-fit between these models. The smaller the value of the rIC, the better the
goodness-of-fit. The rIC for the RE Tobit, after removing the outliers, was 6048 and for the RE Tobit
model, before removing the outliers, was 6202.56. This result suggests that excluding the outliers offers
an improvement. Therefore, the rest of the interpretation of the results will be based on the RE Tobit
model, with the outliers excluded.
$7" 

 
  

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RE Tobit Model RE Tobit model
(before removing outliers) (after removing outliers)
Explanatory Coeff. t-stat Coeff. t-stat
Variables
Government 0.7853 4.00 0.7150 4.05
ownership (GOV)
Free cash flow 1.3283 0.11 4.0360 0.36
(FCF)
Ln(Firm size (MC) 11.3535 3.79 9.0409 3.29
in US$)
Growth rate ʹ0.7939 ʹ0.62 ʹ2.4158 ʹ1.06
(GROW)
Firm leverage ʹ0.0568 ʹ2.15 ʹ0.0495 ʹ2.09
(LEV)
rusiness risk ʹ8.6363 ʹ1.03 ʹ6.1822 ʹ0.81
(rETA)
Firm profitability 0.9813 3.68 1.1923 4.17
(ROE)
Constant ʹ130.5485 ʹ3.42 ʹ102.2439 ʹ2.93
Descriptive
statistics
Wald statistic 131.6200 135.4500
P-value>Wald 0.0000 0.0000
statistic
Observations 929 920
Left-censored 460 455
observations
Uncensored 469 456
observations
Log-likelihood ʹ3063.6868 ʹ2986.5688
function
rayesian 6202.5600 6048.0000
Information
Criterion (rIC)
As discussed in the methodology section, the coefficients of the RE Tobit model represent the
underlying propensity to pay a dividend, that is, the impact of a change in an explanatory variable on the
unconditional expectation of the unobserved or latent variable, * . Figure 1 illustrates the comparison
between the model predicted dividend ratio value at the expected
(*|!) and the observed dividend
ratio.
 h

$ 
 

  

 


It can be seen from Figure 1, that the random effects Tobit model, with country dummies, over-predicts
the dividend ratio. One measure of accuracy is the model prediction error (MPE). This is given by:
X
X

0 Þ    # Þ 

| |
X

| (6)
Þ |
All symbols are as previously defined. The results reveal that the MPE is -1.36%. In addition, a paired
sample t-test was conducted to determine whether the means of the observed value and the model
predicted value were the same. The results are presented in Table 8. In Table 8, it can be seen that the
p-value associated with the test was 0.29, implying that the means were not significantly different.
Observation Mean Standard error
Observed value 920 41.89467 1.810964
Predicted value 920 43.95026 0.7232347
t-statistic ʹ1.0541
p-value 0.292


   
 

 
Nevertheless, the main interest is to estimate both the marginal effects (ME) and the elasticities of both
censored (y) and uncensored (y > 0) variables, with respect to the continuous independent variables
comprised in Model r. The results are illustrated in Table 9 for ME and Table 10 for the elasticities. The
ME and elasticities were evaluated at the means of the variables. It is noticeable that the marginal
effects of market capitalisation (MC) were relatively low. This is for the reason that the units of the MC
were in thousands of US dollars (i.e., US $1000).
$2 

 ( ") $  
   


$ ( ")'
 
  
 
  


$ 
" 
9

$  ""(L) "
"(LM5)
Government ownership 0.3934 0.2801
(GOV)
Free cash flow (FCF) 2.2206 1.5813
Firm size (MC) in 000 8E-06 5.6Eʹ06
US$
Growth rate (GROW) ʹ1.3292 ʹ0.9465
 Firm Leverage (LEV) ʹ0.0272 ʹ0.0194
rusiness risk (rETA) ʹ3.4015 ʹ2.4222
Firm profitability (PROF) 0.6560 0.4671

The sign of the marginal effect of a variable was the same as the sign of corresponding coefficient from
the RE Tobit model (Table 7). As can be seen, the marginal effects of the independent variables on the
censored () and uncensored (y>0) variables were lower than for the marginal effects of the variables on
*. One explanation for this is the relative expected values of latent, censored, and uncensored
variables. These values were found to be
(*|!) M 13.79,
(|!) M 43.95, and
(|>0,!) M 74.37.
If one unit in an explanatory variable was changes, then the amount of the dividend ratio paid by the
firms that always paid a dividend (i.e., y>0) would be less affected than the amount of the dividend ratio
by all firms comprised in the sample. This is also true for the case of the elasticities shown in table 10.
For instance, if all else were equal, a 10% increase in government ownership would lead to an increase
of 1% in the dividend payout ratio for all firms comprised in the sample, and only 0.4% for the firms who
always paid the dividend.
$5" 


 $  
()   
(M5)

$ '
 
  
 
  


$ 
" 
9

$  " 


 
 
 c  

9

$ 9

$
Government ownership 0.0937 0.0391
(GOv)
Free cash flow (FCF) 0.0002 0.0001
Firm size (MC) in 000 US$ 0.1171 0.0488
Growth rate (GROW) ʹ0.0094 ʹ0.0039
Firm leverage (LEV) ʹ0.0682 ʹ0.0284
rusiness risk (rETA) ʹ0.0313 ʹ0.0130
h



$

(*h) 5063 50513F

The statistically significant variables at the 95% confidence level were government ownership (H1), firm
size (H3), firm leverage (H5), and firm profitability (H6). The insignificant variables were free cash flow,
growth rate, and business risk. As a result, the hypotheses H2, H4 and H6 could not be supported by the
data from the 191 non-financial firms considered in this study. The interpretation of the significant
variable is given below.
Government ownership appears to be a statistically significant determinant of dividend policy in the
companies listed on the stock exchanges of GCC countries. This result supports Hypothesis (H1), which
suggests that government ownership and the dividend ratio should have a positive relationship. The
slope coefficient of this variable is 1.08, suggesting that a 1 unit increase in government ownership
would have an increase of 1.08 units in the dividend ratio (ceteris paribus). Furthermore, the elasticity of
the dividend payout ratio, with respect to government ownership, is found to be 0.25, suggesting that a
10% increase in government ownership would increase the dividend ratio by 2.5%. One explanation for
the positive association between the dividend payout ratio and government ownership is that firms in
which the governments own a percentage of their shares are able to pay higher dividends, for the
reason that government ownership itself can attract external funds more easily. Consequently, they
have less difficulty raising external funds to finance investments. In contrast, firms with low, or no,
government ownership are more likely to experience difficulty raising funds and are, therefore, likely to
depend on retained earnings for investment purposes, thus reducing the dividend payout (Gul, 1999a).
Another possible reason for this positive relationship is that in GCC countries, where the legal protection
for outside shareholders is poor, investors need to be protected. For the reason that the government,
which may be seen as acting on behalf of minority shareholders, is a powerful investor, the controlling
shareholders may be forced to pay a large dividend to avoid exploiting minority shareholders, and
thereby, reducing agency conflict (Glen et al., 1995; Naser, 2004). An alternative hypothesis suggests
that government involvement may exacerbate the agency problem. It may also promote a positive
association between their ownership and dividend payout. In this case, agency problems may occur
between citizens (who are not directly in control) and government representatives, since they might not
act in the best interests of citizens. In addition, this may be true between the state-owner and other
managers, for the reason that managers often look to benefit themselves in the expense of outside
shareholders. Therefore, governments may solve this problem by encouraging the company to pay large
dividends, which would reduce free cash flow in the hands of managers, and, at the same time, be in
line with the preference of outside shareholders (Al-Malkawi, 2005).
Furthermore, the governments of GCC countries are looking to diversify their economic resources, for
the reason that of ongoing deficits in state budgets and the negative impact on the economies of GCC
countries of fluctuations in the price of, or decreased demand for, crude oil. One way to diversify their
economic resources, and reduce the dependency on oil revenue and the government sector, would be
to develop and encourage investment in the private sector. Therefore, governments may force firms to
pay large dividends, so that these large dividends can enhance the reputation of the private sector by
suggesting that the exploitation of minority shareholders is avoided. This good reputation may then
attract small or minority shareholders to invest in such companies.
In summary, government ownership was found to have a significant effect in promoting dividend
payouts. There could be several reasons for this association: (i) government ownership itself attracts
external funds more easily, (ii) a government shareholder, in countries where the legal protection is
weak, becomes a powerful investor able to force the firm to disgorge cash, to avoid exploiting minority
shareholders, (iii) to reduce the doubled agency conflict, and (iv) to attract investment in the private
sector.
Firm size was also found to be a statistically significant determinant of dividend policy. This result
supports the Hypothesis (H4) that predicts that firm size and dividend ratio should have a positive
association. The slope coefficient of this variable was 2.02E-05. It is noticeable that the value of this
coefficient is relatively low. This is for the reason that the units of the firm size variable is large, being in
US $1000. Nevertheless, this result suggests that the dividend ratio increases with firm size. In addition,
the elasticity of the dividend payout ratio, with respect to firm size, is found to be approximately 0.3,
suggesting that a 10% increase in firm size, if all else were equal, would lead to an increase of about 3%
in the dividend ratio. This result is in line with previous studies, namely, that larger firms are capable of
paying larger dividends (Eddy and Seifert, 1988; Jensen et al., 1992; Redding, 1997; Holder et al., 1998;
Fama and French, 2000; Manos 2002; Mollah 2002; Travlos et al., 2002; Al-Malkawi 2005). As mentioned
previously, larger firms pay a higher cash dividend for several reasons. First, large firms face high agency
costs as a result of ownership dispersion, increased complexity, and the inability of shareholders to
monitor firm activity closely. Hence, such firms pay a larger dividend to reduce agency costs (Jensen and
Meckling, 1976; Lloyd et al., 1985). Second, as a result of the weak control in monitoring management in
large firms, a large dividend payout increases the need for external financing, which, in turn, leads to the
increased monitoring of large firms by creditors. This may be a quality that is attractive to the
shareholders (Sawicki, 2005). Another explanation for this positive association might be related to large
firms͛ easier access to capital markets, and their ability to raise funds with lower issuance costs for
external financing. Consequently, large firms are better able than small firms to distribute higher
dividends to shareholders (Holder et al., 1998).
The firm profitability ratio appeared to be a very strong and statistically significant determinant of the
dividend payout ratio. This result supports Hypothesis H9, which predicted that firm profitability and the
dividend ratio should have a positive association. The slope coefficient of this variable was 2.89,
suggesting that a 1 unit increase in firm profitability would increase 2.89 units in dividend payout ratio
(ceteris paribus). In addition, the elasticity of the dividend payout ratio, with respect to firm profitability,
was found to be 0.58, suggesting that, if all else were equal, a 10% increase in firm profitability would
lead to an increase of about 5.8% in the dividend payout ratio. This is consistent with the observation
that firms normally pay a higher dividend ratio when there is a rise in firm profitability.
The observed positive association between dividend payout and current firm profitability is in line with
the results of Jensen et al. (1992), Han et al. (1999) and Fama and French (2000). The appearance of
profitability as an significant factor influencing the dividend ratio is supported by Adaoğlu (2000), Pandy
(2001), Wang et al. (2002), and Al-Malkawi (2005), who indicated that the dividend decision of firms
listed on emerging stock exchanges was based on their realised earnings for the same year, which might
illustrate that, for these firms, the dividend smoothness/stability was less significant. This finding might
be related to the fact that in GCC countries, as in other developing countries, there is inferior
shareholder legal protection; consequently, shareholders will take whatever cash dividend they can get
from firm profits (La Porta et al., 2000).
The Leverage ratio was found to be strongly statistically significant and negatively associated with the
dividend payout ratio. This means that if the leverage ratio of a firm increased, the dividend payout ratio
paid by the firm decreased. This is consistent with Hypothesis H6. The marginal effects of this variable
on y and y > 0 were found to be -0.03 and -0.02, respectively, suggesting that a unit increase in the
leverage ratio would lead to a decrease of 0.03 units in the dividend payout ratio for all firms, and 0.02
units for the firms who always paid dividends if all other factors remained constant. The corresponding
elasticities of the dividend payout ratio, with respect to the leverage ratio, were -0.07 and -0.03,
respectively, implying that a 10% increase in the leverage ratio would lead to a decrease of about 0.7%
in the dividend payout ratio for all firms and 0.3% for the firms who always pay dividends, if all other
factors were to remain constant. The reason for this negative association is that highly levered firms
carry a large burden of transaction costs from external financing. In this case, firms need to maintain
their internal source of funds to meet their duties, instead of distributing the available cash to
shareholders as dividends (Crutchley Hansen 1989; Mollah, 2001; Faccio et al., 2001; Aivazian et al.,
2004; Naser et al., 2004; Al-Malkawi, 2005). Furthermore, Jensen et al. (1992) and Agrawal and
Jayaraman (1994) indicated that for the reason that levered firms had a greater commitment to their
creditors, the discretionary funds available to managers would be reduced. This suggests that agency
costs will also be reduced. They also conclude that debt can be a substitution for a dividend.
ã 

  
 
 

The appearance of government ownership, firm size, and firm profitability as the significant explanatory
variables, support the idea that the main aim of non-financial firms listed on the GCC countries is to
reduce agency conflict and maintain firm reputation. Nevertheless, a number of variables appeared to
be statistically insignificant: free cash flow, growth rate, and business risk. What might be notable here
is that free cash flow was the only agency theory explanatory variable found to have no influence on
dividend policy, and therefore, Hypothesis H4 (the positive association between the amount of dividend
payment and free cash flow) cannot be supported. This might be for the reason that the variable,
government ownership, actually forced firms with high free cash flow to pay dividends. La Porta et al.
(2000) supported this view and proposed an outcome model in which firms in countries with high legal
protection paid higher dividends than firms in countries that had poor legal protection.
The common transaction cost variables, growth rate, leverage ratio and business risk, also appeared as
insignificant variables. This suggests that transaction costs do not have a direct influence on the dividend
payout policy. In other words, the firms listed on the GCC countries͛ stock exchanges took into account
agency conflict and firm reputation, more than transaction costs, when they were making the decision
to pay dividends.

F0 
 
The main purpose of this paper was to determine the dividend policies of the nonfinancial firms listed
on the GCC countries (i.e., Kuwait, Saudi Arabia, Muscat, Doha, rahrain) stock exchanges for the period
of 1999-2003, and to explain their dividend payment behaviour. Since a significant number of listed
firms chose not to distribute cash dividends, in some or all of the years within the study period, the
random effects Tobit model was an appropriate model for testing dividend policy. A series of random
effects Tobit models were estimated and seven research hypotheses were tested. The statistically
significant variables comprised government ownership, firm size, leverage ratio and firm profitability.
The results indicated that the firms in which the government owned a proportion of the shares, paid
higher dividends compared to the firms owned completely by the private sector. Furthermore, the
results illustrated that the firms chose to pay more dividends when firm size and profitability were high.
The model also revealed that the leverage ratio was an additional variable that affected the dividend
payout ratio of a firm. One way to extend this study is to investigate the dividend payout ratios of
individual states and compare the results with those of GCC countries. Another is to extend this analysis
by disaggregating the firms into sectors, such as the service and industry sector. Such an analysis will
assist in identifying the sectors whose firms hand out the greatest dividends, and those that offer the
least.
ã
: Global Economy & Finance Journal, Vol. 2 No. 2 September 2009. Pp. 38-63
< 
 
1. How will you evaluate the growth of non-financial firms listed on the GCC countries stock
exchange?
2. Explain how the dividend payout ratio affects the dividend policies of the firms.
 c
8

¢** "ããc"ã*¢"h¢"

c

With the spread of value-based management, corporate finance has also been gaining significance.
Corporate finance is the business function carrying on with financial operations. Financial operations
may comprise obtaining debt or equity financing for new business opportunities or acquisitions, and
finding investment opportunities for earning interest and increasing the cash flows of the company.
Companies may use a financial manager or business analyst to help them decide which opportunities
represent the best return on the company's investment. While the majority of corporate finance
managers spend copious amounts of time finding effective opportunities for the business, issues may
arise that limit the company's ability to accurately assess business opportunities.




 

Companies may find out that not sufficient good corporate finance opportunities are accessible in the
business environment. The majority of companies have a desired rate of return they want to earn when
investing money into new business projects or opportunities. After examining each potential corporate
finance opportunity, companies may decide that the present accessible opportunities do not meet the
company's guidelines. Companies may choose to lower their investment guidelines to accept an
opportunity if a decision completely has to be made. This option may be made by selecting the best
option out a list of bad opportunities.

c $h
 '


 

Companies over and over again make use of external financing when beginning new business operations
or entering new economic markets. Rather than spending cash to pay for these new operations,
companies over and over again use debt or equity financing to pay for these opportunities. The
corporate finance function of a company is generally responsible for obtaining the best available bank
loan or equity investment for new business operations. Companies may be not capable to secure the
right mix of bank loans or equity financing depending on the terms or agreements that must be made to
secure this financing. Failing to secure external financing may leave the company devoid of an ability to
pay for the new business operation.

*
 h'


 

An additional significant function of corporate finance and business is shaping the cash flow from
existing or new business operations. Wrong valuation methods or other analysis derived from the
corporate finance function may effect in lower cash flows than expected. Lower cash flows may
necessitate the company to pay for business operations using capital reserves or external financing.
Using capital reserves will lower the company's ability to pay for other short-term requirements with its
on-hand cash amounts. Using too much external financing to pay for under-performing business
operations may produce new cash outflows in the form of bank loan repayments or interest payments
to investors.
*"ãhc ¢¢." "

Pension fund management necessitates the investment of assets to attain the long-term provision of
funding for retirement. The management of pension funds can be distinguished from mainstream asset
management in that pension fund management characteristically adopts a much more conservative
approach to risk to meet the needs of all pension stakeholders. These stakeholders comprise all existing
and future recipients of income from the pension plan as well as those parties contributing to the plan,
together with employees and the business, government, or union offering employees the benefit of
future retirement provision. As an incentive to decrease their reliance on the state for retirement
provision, pension fund contributions usually receive beneficial tax incentives.

Given the huge significance pension funds hold over the long-term financial happiness of their
beneficiaries, pension fund trustees play a chief role in the effective governance of a fund, with
responsibilities together with ensuring that it sticks rigidly to its mandate and regularly analyzing the
performance and abilities of the entity in point of fact making the investment decisions. The challenges
facing of those overseeing pension funds are frequently evolving, driven by factors such as national
legislation and developments in investment products. For instance, while various pension funds
conventionally favored a mix of equities and bonds to help them achieve their long-term investments,
debate continues about the role of guaranteed return products and hedge funds to augment fund
performance.

Coming in the get up of social changes diminishing the role of the extended family, the ageing of the
population in both OECD and Emerging Market (EME) economies is prompting an increased focus on
provision of sufficient retirement incomes to the elderly, either by public or private means (World rank
1994). Pay-as-you-go pension schemes ʹ where wages are taxed to pay pensions directly ʹ have proven
workable in the past where the population grows rapidly and the elderly cohort is small. Nevertheless,
these systems are facing increasing difficulties as ageing proceeds, for the reason that past benefit
promises cannot be maintained without deplorable increases in contribution rates or vast and growing
government debt. This situation is putting an increased emphasis on advance funding of pensions,
where the transfer element between generations is minimized. Funded systems are themselves not
without risks, notably those arising from capital market volatility, or even poor returns due to economic
performance in the long term, and there are many others relating to aspects such as system design and
institutional background. It is in the context of performance of domestic capital markets that the
potential benefits of international investment come to the fore, as a way of minimizing exposure of
retirement income of the performance of domestic markets. Tensions may nevertheless arise with
domestic regulations that limit such international investment, whose ostensible aim is ʹ mistakenly -
often to ͞avoid risk͟ or, more plausibly, aid the development of domestic capital markets.

   


 



 
 

Õ
 




 






 
For any agent, the most fundamental objective of investment is to attain an optimal trade-off of risk and
return by allocation of the portfolio to appropriately diversified combinations of assets (and in some
cases liabilities, i.e. leveraging the portfolio by borrowing). As derived by Tobin and Markowitz, with a
mean-variance reliant configuration of risk preferences, the precondition for such an optimal trade-off is
ability to attain the frontier of efficient portfolios, where there is no likelihood of increasing return
exclusive of increasing risk, or of reducing risk without reducing return. The exact tradeoff chosen will
depend on objectives, preferences and constraints on investors. In this context, there are common
characteristics of all types of institutional investment. Liabilities are perhaps the the largest part crucial
aspect, in the light of which, asset managers may identify the investors' objectives/preferences and
constraints.
A liability is a cash expenditure made at a specific time to meet the contractual terms of an obligation
issued by an institutional investor. Such liabilities differ in assurance and timing, from known outlay and
timing to uncertain outlay and uncertain timing. In this context, an institutional investor will seek to earn
a satisfactory return on invested funds and to keep a reasonable surplus of assets over liabilities. Risk
must be enough to make sure sufficient returns but not so great as to threaten solvency. The nature of
liabilities also determines the institutions' liquidity needs. Hence, in terms of objectives, there is a need
to assess where on the above-mentioned optimal risk return trade-off the investor wishes to be, in
other words his or her risk tolerance in pursuit of return, which will depend on liability considerations.
This may in turn influence of holdings of international assets.
Uniformly, there are a multiplicity of constraints, all of which may have a marked effect on optimal
portfolios, and thus on holdings of international assets. All of these may link to the nature of the
liabilities, for example:
ͻ liquidity based restraints relate to the right for investors to withdraw funds as a lump sum or the
present needs for regular disbursement;
ͻ the investment horizon connects to the planned liquidation date of the investment, and is often
measured by the concept of effective maturity or duration;
ͻ inflation sensitivity relates to the need to hold assets as inflation hedges;
ͻ tax considerations may change the nature of the trade-off;
ͻ accounting rules can generate different 'optimal' portfolios;
ͻ lastly there is the impact of regulations. resides those linking directly to asset allocation, which
may directly limit international investment, there are sometimes liability restrictions, which may
thus influence preferred asset allocations e.g. by enforcing indexation of repayments or
minimum solvency levels.
After these conditions are taken into account, investment strategies are developed and implemented. A
main decision is to choose the asset categories to be incorporated in the portfolio and whether it should
comprise foreign assets. Following this, the investment process is often divided into more than a few
mechanism, with asset allocation (or strategic asset allocation) referring to the long term decision on
the disposition of the overall portfolio, while tactical asset allocation relates to short term adjustments
to this basic choice between asset categories in the light of short term profit opportunities, so-called
͞market timing͟. For the time being security selection relates to the choice of individual assets to be
held within each asset class, which may be both strategic and tactical. As noted, the above
considerations are based broadly on the mean-variance model, which assumes that the investor chooses
an asset allocation based solely on average return and its volatility. Many considerations in respect of
liabilities affecting risk preferences give rise to alternative paradigms of asset allocation, which may
entail a different approach to investment (rorio et al 1997):
Immunization is a special case of the mean-variance approach which entails that the investor tries to
stabilize the value of the investment at the end of the holding period, i.e. to hold an exclusively riskless
position; this is done characteristically in respect of interest rate risk by appropriately adjusting the
duration of the assets held to that of the liabilities. Since liabilities are characteristically in domestic
currency, it implies holding of domestic assets. It involves a regular rebalancing of the portfolio - as well
as the existence of assets that have a similar duration to liabilities. Matching is a particular case of
immunization where the assets precisely imitate the cash flows of the liabilities, including any related
option characteristics.
Deficit risk and portfolio insurance approaches put a particular stress on avoiding descending moves,
e.g. in the context of minimum solvency levels for pension funds. Therefore, unlike mean-variance they
are not symmetric in respect to the weight put on ascending and descending asset price moves. Shortfall
risk sees the investor as maximizing the return on the portfolio subject to a ceiling on the likelihood of
incurring a loss (e.g. by shifting from equities to bonds as the minimum desired value is approached, or
hedging with derivatives). In portfolio insurance the investor is considered to want to avoid any loss but
to retain upside profit potential. This may be attained by replicating on a continuous basis the payoff of
a call option on the portfolio by trading between the assets and cash (dynamic hedging), or by use of
futures and options per se. ry these means, the value of a portfolio may be prevented from falling
below a given value.
An additional issue is if the benchmark for investment is seen in nominal terms, as implicitly understood
above, or real terms, reflecting liabilities. Asset management techniques which take into account the
nature of liabilities are known as asset liability management techniques (ALM), of which immunization is
a special case. They may be defined as an investment technique wherein long term balance between
assets and liabilities is maintained by choice of a portfolio of assets with comparable return, risk and
duration characteristics to liabilities (although characteristics of individual assets may differ from those
of liabilities). This approach may affect inter alia the suitable degree of international diversification of
the portfolio.
   
 

   
In the context of the above debate, we now go on to assess investment issues for pension funds in more
detail. Pension funds collect pool and invest funds contributed by sponsors and beneficiaries to provide
for the future pension entitlements of beneficiaries (Davis (1995), rodie and Davis (2000)). They hence
supply means for individuals to collect saving over their working life so as to finance their consumption
requirements in retirement. In terms of the framework above, they must shape their assets to the
pertinent time horizon and varying degree of liquidity based constraints. Returns to members of pension
plans backed by such funds may be purely dependent on the market (defined contribution funds) or
may be overlaid by a guarantee of the rate of return by the sponsor (defined benefit funds). The latter
have insurance features which are absent in the former (rodie 1990). These comprise guarantees in
respect of replacement ratios (pensions as a proportion of income at retirement) subject to the risk of
bankruptcy of the sponsor, as well as possible for risk sharing between older and younger beneficiaries.
Defined contribution plans have tended to grow in recent years, as employers have sought to reduce the
risk of their obligations, while employees wish funds that are readily transferable between employers.
For mutually defined advantage and defined contribution funds, the portfolio distribution and the
corresponding return and risk on the assets seek to match or if at all possible exceed the growth of
average labor earnings. This will maximize the replacement ratio (pension as a proportion of final
earnings) obtainable by purchase of an annuity at retirement financed via an occupational or personal
defined contribution fund, and reduce the cost to a company of providing a given pension in a defined
benefit plan. This link of liabilities to labor earnings points to a crucial distinction with insurance
companies, in that pension funds face the risk of increasing nominal liabilities (for example, due to wage
increases), as well as the risk of holding assets, and hence need to trade instability with return. In the
context of the framework above, liabilities have an uncertain outcome and timing. In effect, their
liabilities are characteristically denominated in real terms and are not fixed in nominal terms. Therefore,
they must also focus on real assets which offer some form of inflation protection. Note in this context
that domestic equities are a matching asset when liabilities grow at the same pace as real wages, as is
typical in an ongoing pension fund aiming for a certain replacement ratio at retirement, for the reason
that the labor and capital shares of GDP are roughly constant, and equities constitute capital income.
Domestic bonds are not a good equivalent for real-wage based liabilities although they do match
annuities for pensions.
An extra factor which will control the portfolio distributions of an individual pension fund is maturity -
the ratio of active to retired members. The period of liabilities (that is, the average time to discounted
pension payment requirements) is much longer for an immature fund having few pensions in payment
than for a mature fund where sizeable repayments are essential. A fund which is closing down (or
͞winding up͟) will have even shorter duration liabilities. Following the ALM approach, rlake (1994)
suggests that given the unreliable duration of liabilities it is rational for immature funds having "real"
liabilities as defined above to invest mainly in equities (whose cash flows have a long duration), for
mature funds to invest in a mix of equities and bonds, and funds which are winding-up chiefly in bonds
(whose cash flows have a short duration). Elasticity in the duration of assets, which may need major
shifts in portfolios, is therefore necessary over time.
There are in addition tax considerations. As revealed by rlack (1980), for both defined benefit and
defined contribution funds, there is a fiscal incentive to maximize the tax benefit of pension funds by
investing in assets with the highest probable spread between pre-tax and post-tax returns. In various
countries this tax effect gives an incentive to hold bonds. There is also an incentive to overfund with
defined benefit to maximize the tax benefits, as well as to provide a bigger contingency fund, which is
generally counteracted by government-imposed limits on funding. The accounting and regulatory
framework will influence the approach to investment also. In addition key differences arise in the
liabilities and investment approach of defined contribution and defined benefit funds:

 

$
 
   
In a definite contribution pension fund the sponsors are only accountable for making contributions to
the plan. There is no guarantee concerning assets at retirement, which depend on growth in the assets
of the plan. For that reason the financial risks to which the provider of a defined contribution plan (as
opposed to beneficiaries) is exposed are minimal. In a number of cases, exclusively the sponsor and the
investment managers it employs choose the portfolio distribution, and hence there is a risk of legal
action by beneficiaries against poor investment. rut more and more, employees are left also to decide
the asset allocation (e.g. in the US 401(k) plans). The outstanding obligation on the sponsor is to
maintain contributions.
In relation to portfolio objectives, a defined contribution pension plan should in real seek to enhance
return for a given risk, so as to achieve as high as possible a replacement ratio at retirement. This entails
following closely the standard mean-variance portfolio optimization schema discussed above. As noted
by rlake (1997), in order to choose the suitable point on the frontier of efficient portfolios, it is essential
to determine the degree of risk tolerance of the scheme member; the high the acceptable risk, the
higher the expected value at retirement. The fund will also need to shift to lower risk assets for older
workers as they approach retirement, thus lessening duration as discussed above and lessening
exposure to market volatility abruptly before retirement which might otherwise risk to sharply reduce
pensions. They will imply marked portfolio shifts over time.
Until the approach of retirement requires a shift to bonds, the superior returns on equity and foreign
assets are likely to ensure an important share of the portfolio is accounted for by equities, depending on
the degree of risk aversion. Where employers choose the asset mix, the degree of risk aversion is likely
to be related to the fear of proceedings when the market value of a more aggressive asset mix declines,
where employees choose the asset allocation it is more direct risk aversion.

$ 

   
Contrasting defined contribution funds, defined benefit funds are subject to a wide variety of solvency
risks touching the sponsor. Given there is generally a guarantee of a certain replacement rate at
retirement, the fund is subject to risk from earnings growth. Liabilities will also be prejudiced by interest
rates at which future payments are discounted, and therefore there are significant interest rate risks.
Falling asset returns will affect asset/liability balance. There are also risks of changes in government
regulation (such as those of indexation, portability, vesting and preservation) that can vastly and
unexpectedly change liabilities. The instance of the UK, where such changes have been marked, is
discussed in Davis (2001).
Defined benefit fund liabilities are, owing to the sponsor's guarantee, fundamentally a type of corporate
debt (rodie 1991). Appropriate investment strategies will rely on the nature of the liabilities, together
with whether pensions in payment are indexed and the demographic structure of the workforce.
Investment strategies will also be prejudiced by the minimum-funding rules forced by the authorities
which decide the size of surplus assets, as well as accounting conventions affecting the way shortfalls
are presented in annual reports. These imply a focus on shortfall risk as defined above. To assess the
suitable investment strategies in the light of liabilities, a number of definitions are required. The wind-
up definition of liabilities, the level at which the fund could meet all its current obligations if it were to
be closed down entirely, is known as the accumulated benefit obligation (ArO). The projected benefit
obligation (PrO) implies that the obligations to be funded include a forward-looking element. It is
understood that rights will carry on to accrue, and will be labor earnings indexed up to retirement, as is
normal in a final salary plan. The indexed benefit obligation (IrO) also assumes price-indexation of
pensions in payment after retirement.

If the sponsor attempts to fund the accumulated benefit obligation, and the obligation is solely nominal,
with a minimum-funding requirement in place, it will be suitable to immunize the liabilities with bonds
of the same duration to hedge the interest rate risk of these liabilities. Unhedged equities will just imply
that such funds incur preventable risk (rodie (1995)), even though they may be useful to provide extra
return on the surplus over and above the minimum funding level. Regulations and practice differ
between countries as to which of these is aimed for. With a projected benefit obligation target, an
investment policy based on diversification may be most appropriate, in the belief that risk reduction
relies on a maximum diversification of the pension fund relative to the firm's operating investments
(Ambachtsheer 1988), which could certainly include foreign assets. Furthermore, it is normal for defined
benefit schemes which offer a certain link to salary at retirement for the liability to include an element
of indexation. Then fund managers and actuaries characteristically suppose that it may be suitable to
include an important proportion of real assets such as equities and property in the portfolio as well as
bonds. ry doing this, they unreservedly diversify between investment risk and liability risk (which are
largely risks of inflation). As noted by rlake (1997), minimum funding levels and limits on overfunding
offer tolerance limits to the variation of assets around the value of liabilities. If the assets are selected in
such a way that their risk, return and duration characteristics match those of liabilities, there is a
"liability immunizing portfolio". This protects the portfolio against risks of variation in interest rates, real
earnings growth and inflation in the pension liabilities. Such a strategy, which determines the overall
asset allocation between broad classes of instrument, may be assisted by an asset-liability modeling
exercise (ALM) as detailed above. Severe minimum funding rules will overlay this with shortfall risk
conditions also.

"9"¢."rc;c¢..*9¢""ã

In a leveraged buyout, a company is taken on by a specialized investment firm by means of a relatively

small portion of equity and a comparatively outsized portion of outside debt financing. The leveraged
buyout investment firms nowadays refer to themselves (and are usually referred to) as private firms. In
a typical leveraged buyout transaction, the private equity firms buys mainstream control of an existing
or mature firm. This arrangement is distinct from venture capital firms that characteristically invest in
young or emerging companies, and characteristically do not obtain majority control. In this section we
spotlight particularly on private equity firms and the leverages buyouts in which they invest, and we will
use the terms private equity and leveraged buyouts synonymously.

Leverages buyouts first came out as a significant phenomenon in the 1980s. As leveraged buyout activity
enlarged in that decade, Jensen (1989) predicted that the leveraged buyout organizations would finally
become the overriding corporate organizational form. He argued that the private equity firm itself
combined concentrated ownership stakes in its portfolio companies, high-powered incentives for the
private equity firm professionals, and a slant, efficient organization with negligible overhead costs. The
private equity firm then applied performance-based managerial compensation, highly leveraged capital
structures (often relying on the junk bond financing), and active governance to the companies in which
it invested. As per the Jensen, these structures were superior to those of the typical public corporation
with dispersed shareholders, low leverage, and weak corporate governance. A few years later, this
forecast seemed untimely. The junk bond market crashed; a large number of high-profile leveraged
buyouts resulted in default and bankruptcy; and leveraged buyouts of public companies (so called
public-to-private transactions) virtually disappeared by the early 1990s.

rut the leverages buyout market had not diedͶit was only in hiding. At the same time as leveraged
buyouts of public companies were comparatively scarce throughout the 1990s and early 2000s, private
equity firms continued to purchase private companies and divisions. In the mid-2000s, public-to-private
transactions re-emerged when the United States (and the rest of the world) experienced a second
leveraged buyout boom.

In 2006 and 2007, a record amount of capital was dedicated to private equity, both in nominal terms
and as a fraction of the overall stock market. Private equity commitments and transactions rivaled, if not
caught up with the activity of the first wave in the late 1980s that reached its peak with the buyout of
RJR Nabisco in 1988. Nevertheless, in 2008, with the turmoil in the debt markets, private equity appears
to have declined again.

When a listed company is took on and consequently delisted, the transaction is referred to as a public-
to-private or going-private transaction. As most such transactions are financed by substantial borrowing,
which is used to repurchase most of the exceptional equity, they are called leveraged buyouts (LrOs).
An impression of the various types of LrO is given in Table 6.1. Four categories are usually recognized:
management buyouts (MrOs), management buyins (MrIs), buyin management buyouts (rIMrOs), and
institutional buyouts (IrOs).

Table 6.1: Summary definitions of types of public-to-private transaction


 


 
LrO Leveraged buyout. Acquisition in which a nonstrategic bidder acquires a listed or non-listed
company utilizing funds containing a proportion of debt that is substantially above the
industry average. If the acquired company is listed, it is subsequently delisted (in a going-
private or public-to-private transaction)
MrO Management buyout. An LrO in which the target firm͛s management bids for control of the
firm, often supported by a third-party private equity investor
MrI Management buyin. An LrO in which an outside management team (often backed by a third-
 party private equity investor) acquires a company and replaces the incumbent management
team
rIMrO ruyin management buyout. An LrO in which the bidding team comprises members of the
incumbent management team and externally hired managers, often alongside a third-party
private equity investor
IrO Institutional buyin. An LrO in which an institutional investor or private equity house acquires
a company. Incumbent management can be retained and may be rewarded with equity
participation
Reverse A transaction in which a firm that was previously taken private reobtains public status
LrO through a secondary initial public offering (SIPO)


  
 
h

 .
*




  ã 

 ¢
   

The fundamental dilemma of principal-agent models is how to get the manager (the agent) to act in the
best interests of the stockholders (the principals) when the agent has interests that deviate from those
of the principals and an informational advantage.

ͻ The incentive rearrangement supposition   r 

states that the gains in stockholder ͻ Involves the management team͛s purchase of
wealth that arise from going private are the bulk of the firm͛s shares.
ͻ Create a win-win situation for shareholders
a result of providing more rewards for
who receive a premium for their stock and
managers (through an increased management who retain control.
ownership stake) that persuade them to ͻ To avoid lawsuits, the price paid must
act in line with the interests of investors. represent a higher premium to the current
In addition, in the case of an institutional market price.
buyout, the concentration of ownership ͻ Alternatively, the target may make itself less
attractive by divesting assets the bidder wants.
leads to enhanced monitoring of
ͻ Cash proceeds of the sale could fund other
management.
defenses such as share buybacks.
ͻ The free cash flow supposition suggests
that the expected stock returns follow from debt-induced mechanisms that force managers to
pay out free cash flows. Free cash flow is the cash flow in surplus of that necessitate to fund all
projects that have positive net present value (NPV) when discounted at the suitable cost of
capital. The high leverage does not allow managers to grow the firm further than its optimal size
(so-called ͞empire building͟) and at the expense of value creation.

  r 

The considerable increase in cash flow creates a main tax shield, which increases the pre-transaction (or
pre-recapitalization) value. After the buyout, firms pay almost no tax for a period of at least five years.
Accordingly, the (new) stockholders gain, but the government loses out.


      

The cost of keeping up a stock exchange listing is
extremely high. Even though the direct costs (fees paid 
r

to the stock exchange) are comparatively small, the
indirect costs of being listed are substantial (for
example the cost of complying with corporate
governance/transparency regulations, which
necessitates larger accounting/legal departments, the
cost of investor relations managers, and the cost of
management time in general, etc.). For a medium-sized
listed company these indirect costs are predictable at
US$750,000ʹ1,500,000 annually. The going-private
transaction eliminates several of the transaction costs.
ͻ rorrowed funds are used to pay for all
or most of the purchase price.
ͻ Can be of an entire company or
divisions of a company
ͻ The tangible assets of the company are
used as collateral for the loans
ͻ Investors in LrOs are referred to as
financial buyers for the reason that
they are primarily focused on relatively
short- to intermediate-term financial
returns

Ä
     r 
  ã 


Gains in stockholder wealth that take place from going private outcome from the expropriation of value
belonging to pre-transaction bondholders. There are three mechanisms during which a firm can transfer
wealth from bondholders to stockholders: an unanticipated increase in the asset risk (the asset
substitution risk); large increases in dividends; or an unexpected issue of debt of higher or equal
seniority, or of shorter maturity. In a going-private transaction, the last mechanism in specificity can lead
to considerable expropriation of bondholder wealth if protective covenants are not in place.

i 
   


Frightened of losing their jobs if a antagonistic suitor takes control, the management may decide to take
the company private. Thus, an MrO is the ultimate defensive measure against a hostile stockholder or
tender offer.

c 


 ã


 


 
$'  r  r
As a firm is a portfolio of projects, there
may be asymmetric information between
the management and outsiders
concerning the maximum value that can
be realized with the assets in place. If
management believes that the share price
is undervalued in relation to the firm͛s
true potential, they may privatize the firm
through an MrO. Alternatively, if an
external party believes that it is able to
generate more value with the assets of
the firm, the firm may be taken over by
means of an IrO or MrI.
ͻ MrO leads to private companies while LrO leaves the
company publicly traded with shareholders receiving
͞stub͟ equity in addition to cash payout.
ͻ Under the MrO, the company saves on public
reporting costs, but its equity shares remain illiquid
securities. LrO preserves equity liquidity but exploits
no (or few) savings on reporting.
ͻ Under the MrO, owners are insiders. In LrO, equity
investors remain outsiders
ͻ Under MrO, control of the firm changes. In LrO,
control may not necessarily change since the stub
equity remains in the hands of public shareholders.
ͻ The MrO creates strong conflict of interests, requiring
the board to actively represent shareholders in the
buyout negotiations. In LrO, ordinary business
judgment rules applies.
#'#
 ¢
 *


*

 r


The premiums (relative to the pre-transaction share price) are in line with those on ordinary takeover
transactions: Over last 25 years they have been in the range 35% to 45%. The cumulative average
abnormal returns (CAARs) calculated over two months around the event date (the announcement of the
going-public transaction) average around 25%, which is similar to those of ordinary takeover
transactions. The abnormal returns are equal to the realized returns corrected for the market
movement (the return of the market index) and the riskiness of the firm (the beta).

 *    r*
 

Figure 6.1 shows the structure of the buyout process, the main research questions for each phase of the
process, and their explanations. The first phase (Intent) consists of the identification of good LrO
candidates; the second phase (Impact) comprises the actual LrO and an analysis of the expected
returns; the third phase (Process) consists of the value creation while the firm is privately listed; and the
fourth phase (Duration) concerns the duration of the private phase until the main shareholder exits
through an IPO or trade sale. At every phase, eight main hypotheses or triggers can be examined:
realignment of incentives, acquisition of control, reduction of free cash flow, wealth transfers from
various stakeholders, tax benefits, a reduction of transaction costs, the importance of takeover defense
mechanisms, and undervaluation of the target firm.
 

h

 *&     




What makes firms good buyout candidates? The ͞Intent͟ phase comprehends the distinctiveness of
firms prior to their decision to go private and compares these features to those of firms which stay
publicly listed. Out of the eight value drivers (discussed above) to go public in the United States, the
decrease in taxation resulting from the tax shield is the major one. Therefore, firms with a high tax bill
may regard as going private with a lot of leverage provided that a stable cash flow stream enables the
firm to service the debt. In addition, firms with considerable free cash flow (excess cash) that could lead
to value-destroying investments have also been exposed to be prime candidates for a public-to-private
transaction. In the United States, decisions to go private in the 1980s were frequently motivated by anti-
takeover defense strategies.

How does the market react to a buyout? The impact of an LrO offer can be anticipated by analyzing the
instant stock price reaction or the premiums paid to pre-transaction stockholders. The CAARs and
premiums replicate the expected value creation when the firm becomes privately held. They are larger
at the announcement for firms in which pre-transaction managers hold small equity stakes, which
entails that the buyout may encourage a realignment of incentives. In addition, the fact that the buyout
will reduce large free cash flows triggers positive share price returns. Also, for firms paying a large
amount of tax, the buyout announcement leads to positive abnormal returns. As a final point,
bondholder wealth transfers appear to exist but are playing only a very limited role in the wealth gains
of pre-buyout stockholders.

Is value created during the private phase? Just the once a company is privatized, what post-buyout
processes lead to more wealth creation? The post-transaction performance improvements are in line
with those anticipated at the announcement of a going-private transaction. The causes of the
performance and efficiency advances are mainly the organizational structure of the LrO (high leverage
and strong (managerial) ownership concentration). In the private phase, a firm͛s productivity increases
due to a focused strategy and the avoidance of excess growth. Post-buyout performance improvements
arise from an improved quality of the Research and Development function and intensified venturing
activities. This revamped entrepreneurial spirit follows from reduced stockholder-related agency costs.
Also typical of firms that go private is an important improvement in the management of working capital.

How long it is before a firm is relisted on the stock exchange? An investor may make a decision to end a
company͛s private status through an exit via a SIPO (secondary initial public offering, or reverse LrO).
Particularly in the United States, some firms seem to use the organizational form of a privatization
transaction as a impermanent shock therapy to enable them to restructure professionally, while others
view the LrO as a sustainable and superior organizational form. Firms that do a reverse LrO have usually
been private for three to six years. In Europe, major stockholders generally do not exit via a SIPO but
perform a trade sale. The long life of private ownership and its determinants are studied in the literature
on duration.
 ã' !


One of the key characteristics of going private through an LrO is the high-leverage structure that results.
Nevertheless, the discipline of high leverage can also be induced by a leveraged recapitalization without
privatization. Denis (1994) investigated the difference between the two approaches by contrasting two
grocery store firmsͶKroger, which undertook a recapitalization, and Safeway, which took the LrO
route. The higher leverage and the pressure to generate cash led to a performance increase at Kroger,
but the performance improvement at Safeway was importantly higher. Why should this have been so?
! Top managers at Safeway put part of their wealth at stake and hold substantial equity stakes
(amounting to a total of about 20%) such that every managerial decision has a important direct
impact on their wealth. In addition, management is even more directed towards a focus on
value as its bonuses are linked to the market value of assets and managers receive stock
options.
! There is a major external stockholder (the private equity firm Kohlberg Kravis Roberts, or KKR)
that monitors the firm closely and ensures that management does not maximize its private
benefits at the expense of other stockholders and the firm itself.
! Safeway restructured the board to consist of management and representatives of KKR, who
provided expertise on corporate restructuring.
! Safeway restructured its operations more drastically than Kroger, closing stores that did not
generate sufficient operational cash flows. It also cut back on discretionary expenses, such as
advertising and maintenance, to meet its short-term debt obligations, and it cut non-core
business.
! Safeway removed leverage-induced cash flow streams as fast as possible through asset sales in
order to increase capital expenditures.
 
 
Firms that undergo leveraged (management) buyouts have important advantages over publicly listed
firms. First, the high leverage creates value through the tax shield. Second, the management is
incentivized to focus on value creation for the reason that it (co-) owns the firm (in the case of a
MrO/MrI) or for the reason that strict monitoring of the incumbent management is induced by the
major stockholders (in the case of an IrO). The organizational structure reduces the firm͛s free cash flow
such that money is not squandered by investing in negative-NPV projects. The private status of the firm
requires little information disclosure compared to a listed firm, which allows the firm to avoid expenses
related to compliance with the regulations on corporate governance/transparency.
It should be emphasized that not every firm is a good candidate for LrO. The requirements are: stable
cash flows, low and predictable capital investment needs, a liquid balance sheet with collateralizable
assets, an established market position, and being in a recession-proof industry.

"?"c9" *"ã¢* ¢ã

Opposite to media ͞noise,͟ the issue of executive compensation is not a recent predicament: economist
Adam Smith analyzed it more than 200 years ago. Weak boards, discrete ownership and an ill-informed
financial community all add to the problem. rut is there a solution? Nowadays, more people than ever
before are covered by executive compensation and employee benefits plans and agreements, which
have turn into vital tools to attract and retain top talent.

*


 
"
 
 
() *
  : The company should have a clear arching over compensation philosophy. The
philosophy should encourage an alignment of interests between management and
shareholders. The company͛s compensation philosophy should aim to create long-term value
while not incentivizing excessive risk taking. The company philosophy should be flexible enough
to allow for sensible and fair return in changing market conditions.
ͻ  
  
: The compensation committee should be accountable for
developing the philosophy and making sure that it becomes part of the company culture.
Roles and accountabilities of members, committee makeup, and information gathering and
processing should also be addressed.
ͻ * "  : The company philosophy should address total compensation as well as the
relative mix of base, bonus, and long-term incentive elements of the plan. In addition, the
company philosophy should address the use of cash, equity, and equity-like compensation.
ͻ 
   : The company philosophy should address the risks to compensation
expenditures as well as risk posed by compensation metrics. Part of this risk analysis should
include the issue of unintended drivers or consequences related to incentive compensation.
(4) 
 : The design of the company͛s compensation policy should be comprehensive and discuss
in detail all relevant components. A important portion of plans should be performance based.
Discussion should include why certain elements were used as well as why certain elements were
not incorporated.
ͻ   
 r  : The policy should contain the intended forms of incentive and bonus
compensation. In addition, the policy should discuss the rationale for use of guaranteed
bonuses, the types of metrics used, and the rationale behind adjusted presentation metrics
and non-financial metrics.
ͻ "%
  
 : The policy should address each form of equity and equity-like
compensation and the company͛s overall objectives in utilizing these tools. Conversation of
award structures, as well as the size, timing, valuation, and terms of grants should be
included. Additionally, the company͛s approach to equity ownership and retention
guidelines should be included.
ͻ 

  , 


: Companies should give clear policies on repricing and how
compensation plans might lead to dilution of existing shareowners.
ͻ  
 ¢

   : The policy should enclose the parameters by which the

company will make use of employment agreements, severance agreements or other
contractual arrangements including post-employment agreements.
(6) 
 
 : A well expressed compensation plan increases efficiency and may reduce the
instances in which the company and investors are surprised by outcomes related to the
compensation program, thereby reducing the negative reaction in the marketplace to
compensation related events.
ͻ h 
 
 : Companies should provide full disclosure of plans and how they are
intended to be used.
ͻ *
" 
: Philosophy, plans, and disclosures should be easily understood and presented
in plain English.
(3) ¢ $

: The compensation committee is finally accountable for designing,
implementing, monitoring, and evaluating the executive compensation program.
ͻ    
 
$


 : Clearly defined responsibilities of the compensation committee
demonstrate rigor in creating and implementing compensation plans. The compensation
committee charter should clearly outline these roles and responsibilities.
ͻ ã 
 
¢
: Compensation plans, repricing of awards within plans, and an annual
advisory vote on compensation should always be submitted for shareholder approval.
 (1)    : The compensation process should be conducted by independent compensation
committee members utilizing only independent advisors and compensation consultants.

"
 
 
*

  


 


Executive compensation does not merely indicate base salary; it is the total remuneration an upper-level
manager receives in a corporation. This normally comprises benefits such as bonuses, deferred and
restricted stock, vesting periods, pensions and perquisites, as well as terms of employment as well as
performance metrics, clawback provisions, and golden parachutes.

¢


  
 

Contemporary situation risks more than bad public relations for public companies: there is a danger of
missing out on an opportunity to get better incentives for top managers to increase the long-term value
of their enterprises. Taking benefit of this opportunity has main ramifications not only for corporate
stakeholders, but for society in common, as it has the potential to create more productive, durable, and
valuable companies.

There is a real necessity to bring a unruffled analysis to executive compensation and go beyond the
superficial caricatures of unbridled greed. Economics can help by shining a light on the purpose of a
corporate form of organization and the costs and benefits of comparative mechanisms for aligning
executives͛ behavior with shareholders and the broader stakeholder community. Remember that well-
constructed executive compensation packages are necessary but not adequate for long-term value
creation.


+ $&


What is the aim of a corporation? Maximizing the long-term total enterprise value of the firm has long
been understood as the chief corporate mission. rasically said, this means expanding the organization͛s
market reach or improving real productive capacity. Demonstrating a culture of long-term value creation
implies gaining the loyalty and commitment of all constituencies, comprising employees, suppliers, and
the wider community. The main challenge for management is to create the corporate vision, strategy,
and tactics to unite and guide all constituents. So much depends on the stock of trust and flow of honest
information.

¢

 
  

A corporation requires to make sure that executive leaders͛ incentives are aligned with shareholder
interest in long-term value creation. Contrasting owner-managers of small firms, executives at large
enterprises often have only a small portion of their own equity at stake. Nevertheless, this disparity
leads to a gap in their interest as the ͞agent͟ looking after the interest of the ͞principals͟ (e.g.
shareholders and debtholders). What͛s more, they have an information advantage over principals,
which can confer rise to a serious conflict of interests and accountability problems. The economics of
principals and agents helps organize thinking about how the structure of the CEO͛s compensation will
have an effect on managerial behavior in quest of the objectives of the firm͛s various stakeholders.

The principal-agent relationship is complicated and costly to uphold effectively over the long run, which
means it is critical to take advantage of alternative alignment forces and mechanisms such as
government regulation to monitor against fraud and accounting manipulation. Furthermore, the market
for corporate control offers outside active investors and strategic companies a way to act as a corrective
force against managers who do not maximize the value of their firms and wander away too far from
their shareholders͛ interests. rut recent events suggest that this discipline has restrictions, particularly
in the recent era of overvalued equity.

 

.
 

Corporate governance is an instrument for aligning principal-agent interests and incentives, encouraging
accountability. How does it accomplish this? Corporate governance seeks to reconcile the relationships
among the CEO, board members, stockholders, and the outside financial community of analysts,
bondholders, and other creditors by clearly assigning responsibilities, measuring performance, and
worthwhile or penalizing managers in line with their impact on the firm͛s long-term value creation.

There are some persuasive examples that the sine qua non of a well-run, healthy company is successful
coordination of the terms of executive compensation with the corporate governance function: rules,
monitoring, and other incentives promoting effective relationships among significant constituencies.
Corporate governance, in theory at least, serves as a kind of ͞check and balance͟ for a corporation to
make sure that executive compensation packages attract and retain the right people, hasten the
departure of the wrong people, and provide incentives for high performance.


:
 ã 
A



An important part of the problem in executive compensation can be traced to how compensation
packages evolved and became more closely tied to short-term stock prices. For instance, pay plans have
tended to move away from using fixed salaries. Compensation plans are now concerted in stock options.
And deferred stock and stock purchase options, which tend to vest over short time periods, are
common. Furthermore, options are characteristically tied to short-run publicly traded stock prices. The
table overleaf shows the recent trend of executive compensation increasing in the form of equity.

Of course, CEOs are supposed to be paid for performance, but this shift in the make-up of compensation
packages has led to some unforeseen repercussions: it has skewed managerial decisions to favor the
short term and created a marketplace hothouse of overvalued equity.

The introduction of stock options and limited stock grants with such features as short-term vesting
periods seemed to be the universal remedy for aligning shareholder and manager interests. Equity
compensation soon evolved into the greatest portion of total executive compensation. At the same
time, its growth facilitated a climate where information became less reliable, even though superficially
more plentiful, making it more and more complex for analysts or investors to make reliable decisions ʹ
for example, financial analysts underestimated Microsoft͛s quarterly earnings 41 out of 42 times,
according to an SEC investigation and cease and desist order in 2002.

Imagine the CEO of an international engineering and construction company grappling with whether to
bite the bullet and overhaul the firm͛s engineering software and invest in an even more costly three-
year employee training program. If carried out, the costs of the investment could impact earnings and
the company͛s share price, affecting the CEO͛s various stock options and restricted stock share over the
next three years. Delaying the investment may advantage the value of the CEO͛s personal stock options,
but the longer he waits, the greater the decline in long-term company and shareholder value as his
engineers carry on to fall behind.


 
  


.
 

So, what can this examination tell us about the present argument over executive pay packages? Is the
argument symptomatic of a real problem, or an unfortunate matter of timing and appearances? What is
clear is that executive compensation and corporate governance are inextricably linked and considerable
effort and cost are obligatory to better align incentives and reduce opportunism of all corporate
stakeholders ʹ top executives, board chairs and members, stockholders, debt holders ʹ and the financial
community.

The seminal idea behind the use of limited stock grants and stock options was to augment the
performance of managers, or make ͞pay for performance͟ a reality in the corporate world. rut the
condition was still far removed from the ideal of all responsibility and the fruits of presentation
concentrated in the owner-manager. Giving way to the stock options or limited stock shares that vested
quickly or over short time-horizons contributed nothing toward managers having ͞skin in the game.͟
(Private equity, hedge funds, LrOs and other alike entities have basically solved the ͞skin in the game͟
problem in the way that managing partners are compensated.)
It soon became clear that grants of stock options and limited stock were not free of cost to companies
and were also failing to have the preferred effect of making top management more vested in
companies͛ long-term goals. In reply, a number of corporations began to require CEOs to purchase and
hold stock with after-tax dollars or variants with similar effects. A number of companies that exchanged
cash bonuses, grants of options or restricted stock for their longer-term equivalents include ADC
Telecommunications, Arkla, Avon, raxter, rlack & Decker, Clorox, EKCO and General Mills. FTI
Consulting will be monitoring the performance of these companies and others that adopt similar
compensation strategies over the coming years.

  





Constructing a culture of accountability and responsibility is necessary to address issues around

executive compensation. retter transparency and credible, independent checks and balances are the
least requirements to regain shareholder and broader stakeholder trust. Companies should also put in
place a system that describes potential conflicts of interests and implements countervailing measures.
These comprise:

! Avoid the intrinsic risk of hiring the same compensation firm for the rank-and-file employees
and the CEO or other top managers.
! Put into practice a set of measures to monitor accounting and other reporting practices that
recommend weaknesses in corporate governance.
! Do not provide multi-period compensation packages.
! Cautiously monitor CEO and financial analyst relationships.
! Set up an independent compensation committee composed of board members without CEO
participation.
! Commission financial analysis of compensation packages with another scenarios and expected
outcomes in terms of attraction, separation, and incentives.
! Limit to only the CEO and certain top executives the grant of options and deferred stock, and
with these, make every effort to set up true estimates of costs to the company and their impact
on the CEO and firm value.

As a significant component of corporate governance, executive compensation must continually strive to

align the incentives of top managers with shareholders and broader stakeholders. As the value added by
management is complex and costly to measure, monitor and verify, this is a complex and challenging
responsibility for which much is at stake.

Obviously, ensuring effective measurement and monitoring of the value added by top management is
complex and costly but, equally, it is necessary for protecting stakeholders and increasing long-term
total enterprise value of the firm.

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Corporate restructuring is one of the most intricate and basic phenomena that management confronts.
Each company has two opposite strategies from which to choose: to expand or to refocus on its core
business. While diversifying represents the expansion of corporate activities, refocus characterizes a
concentration on its core business. From this viewpoint, corporate restructuring is reduction in
diversification.
Corporate restructuring is an episodic exercise, not related to investments in new plant and machinery
which involve an important change in one or more of the following
Š Pattern of ownership and control
Š Composition of liability
Š Asset mix of the firm.
It is an all-inclusive process by which a co. can consolidate its business operations and make stronger its
position for achieving the desired objectives:
(a) Synergetic
(b) Competitive
(c) Successful
It comprises important re-orientation, re-organization or realignment of assets and liabilities of the
organization through cognizant management action to improve future cash flow stream and to make
more profitable and well-organized.



 



Corporate restructuring is the procedure of redesigning one or more aspects of a company. The process
of reorganizing a company may be implemented due to a number of diverse factors, such as positioning
the company to be more competitive, survive a presently unfavorable economic climate, or poise the
corporation to move in a totally new direction. Here are some instances of why corporate restructuring
may take place and what it can mean for the company.
Restructuring a corporate entity is often an essential when the company has grown to the point that the
original structure can no longer competently manage the output and general interests of the company.
For instance, a corporate restructuring may need for spinning off some departments into subsidiaries as
a means of creating a more effective management model as well as taking benefit of tax breaks that
would allow the corporation to divert more revenue to the production process. In this situation, the
restructuring is viewed as a positive sign of growth of the company and is often welcome by those who
wish to see the corporation get a larger market share.
Corporate restructuring may also take place as a result of the acquisition of the company by new
owners. The acquisition may be in the form of a leveraged buyout, a hostile takeover, or a merger of
some type that keeps the company intact as a subsidiary of the controlling corporation. When the
restructuring is due to a hostile takeover, corporate raiders often implement a dismantling of the
company, selling off properties and other assets in order to make a profit from the buyout. What
remains after this restructuring may be a smaller entity that can continue to function, albeit not at the
level possible before the takeover took place
In common, the idea of corporate restructuring is to allow the company to continue functioning in some
manner. Even when corporate raiders break up the company and leave behind a shell of the original
structure, there is still frequently a hope, what remains can function well adequate for a new buyer to
buy the diminished corporation and return it to profitability.
*
 

 


A
Š To enhance the share holder value, The company should continuously evaluate its:
1. Portfolio of businesses,
2. Capital mix,
3. Ownership &
4. Asset arrangements to find opportunities to increase the share holder͛s value.
Š To focus on asset utilization and profitable investment opportunities.
 Š To reorganize or divest less profitable or loss making businesses/products.
Š The company can also enhance value through capital Restructuring, it can innovate securities
that help to reduce cost of capital.
 



 

 



1. To improve the company͛s ralance sheet, (by selling unprofitable division from its core
business).
2. To accomplish staff reduction ( by selling/closing of unprofitable portion)
3. Changes in corporate mgt
4. Sale of underutilized assets, such as patents/brands.
5. Outsourcing of operations such as payroll and technical support to a more efficient 3rd party.
6. Moving of operations such as manufacturing to lower-cost locations.
7. Reorganization of functions such as sales, marketing, & distribution
8. Renegotiation of labor contracts to reduce overhead
9. Refinancing of corporate debt to reduce interest payments.
10. A major public relations campaign to reposition the co., with consumers.



 



Corporate Restructuring entails a range of activities including financial restructuring and organization
restructuring.

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Financial restructuring is the restructuring of the financial assets and liabilities of a corporation to to
create the most advantageous financial atmosphere for the company. The process of financial
restructuring is often connected with corporate restructuring, in that restructuring the general function
and composition of the company is likely to effect the financial health of the corporation. When
finished, this reordering of corporate assets and liabilities can help the company to remain competitive,
even in a miserable economy.

Almost all businesses goes through a phase of financial restructuring at one time or another. In a few
cases, the process of restructuring takes place as a means of apportioning resources for a new
marketing campaign or the launch of a new product line. When this happens, the restructure is often
seemed as a sign that the company is financially established and has set goals for future growth and
expansion.


 



 






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Corporate restructuring may take place due to the acquisition of the company by new owners. The
acquisition may be in the shape of a leveraged buyout, a hostile takeover, or a merger of some type that
keeps the company intact as a subsidiary of the controlling corporation.
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A hostile takeover is a kind of corporate takeover which is carried out against the wishes of the board of
the target company. This unique type of acquisition does not occur nearly as frequently as friendly
takeovers, in which the two companies work together for the reason that the takeover is perceived as
beneficial. Hostile takeovers can be traumatic for the target company, and they can also be risky for the
other side, as the acquiring company may not be able to obtain certain relevant information about the
target company.
Companies are purchased and sold on a daily basis. There are two kinds of sale agreements. In the first,
a merger, two companies come together, blending their assets, staff, facilities, and so forth. After a
merger, the original companies cease to exist, and a new company comes up in its place. In a takeover, a
company is purchased by another company. The purchasing company owns all of the target company's
assets as well as company patents, trademarks, and so forth. The original company may be completely
swallowed up, or may operate semi-independently under the umbrella of the acquiring company.
Characteristically, a company which wishes to acquire another company approaches the target
company's board with an offer. The board members mull over the offer, and then choose to accept or
reject it. The offer will be accepted if the board believes that it will promote the long term welfare of the
company, and it will be rejected if the board dislikes the terms or it feels that a takeover would not be
beneficial. When a company engages in the takeover after rejection by a board, it is a hostile takeover. If
a company bypasses the board completely, it is also termed a hostile takeover.
Publicly traded companies are at risk of hostile takeover for the reason that opposing companies can
purchase large amounts of their stock to gain a controlling share. In this instance, the company does not
have to respect the feelings of the board for the reason that it already essentially owns and controls the
firm. A hostile takeover may also comprise tactics like trying to sweeten the deal for individual board
members to get them to agree.
An acquiring firm takes a risk by attempting a hostile takeover. For the reason that the target firm is not
cooperating, the acquiring firm may without knowing take on debts or serious problems, since it does
not have access to all of the information about the company. A lot of firms also have trouble getting
financing for hostile takeovers, since some banks are reluctant to lend in these situations.




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A merger takes place when two companies unite to form a single company. A merger is very alike to an
acquisition or takeover, except that in the case of a merger existing stockholders of both companies
comprised retain a shared interest in the new corporation. ry distinction, in an acquisition one company
purchases a bulk of a second company's stock, creating an uneven balance of ownership in the new
combined company.
The acquisition of a business may be structured in a number of ways, comprising, an asset sale, a stock
sale, or a merger. The structure of the acquisition will be determined by a variety of accounting,
business, legal, and tax considerations. In spite of the structure of the transaction, acquisition
agreements have the subsequent four common and very significant features which are examined in this
discussion: (a) representations and warranties; (b) pre-closing covenants; (c) conditions precedent to
closing; and (d) indemnification.


  
  :

 
 

The vendor and the purchaser will make delegacies and warranties to the other in the acquisition
agreement. The vendor͛s representations and warranties characteristically make up the major part of
the acquisition agreement. Delegacies and warranties serve three significant purposes. First, they are
informational. The seller͛s representations and warranties, united with the buyer͛s due diligence,
facilitate the buyer to learn as much as possible about the seller͛s business prior to signing the definitive
acquisition agreement. Second, they are protective. The seller͛s representations and warranties provide
a mechanism for the buyer to walk away from, or perhaps to renegotiate the terms of, the acquisition, if
the buyer discovers facts that are contrary to the representations and warranties between the signing
and the closing. Third, they are supportive. The seller͛s representations and warranties make available
the framework for the seller͛s restitution obligations to the buyer after the closing.

Prior to signing the acquisition agreement, the buyer will want to learn as much as possible about the
seller͛s business. Consequently, the buyer will require the seller to make extensive representations and
warranties about its business. Several of these representations and warranties will be specific to the
seller͛s industry. Nevertheless, the most common representations and warranties comprise:

(a) corporate organization, authority, and capitalization;

(b) assets;
(c) liabilities;
(d) financial statements;
(e) taxes;
 (f) contracts, leases, and other commitments;
(g) employment matters;
(h) compliance with laws and litigation;
(i) product liability; and
(j) environmental protection.

From the seller͛s viewpoint, if the buyer is paying the purchase price in cash at the closing, the most
significant representations and warranties the seller can elicit from the buyer are those governing the
buyer͛s corporate authorization and financial condition (i.e., the buyer͛s ability to pay the purchase
price). If the buyer is paying the purchase price over time or by issuing stock, the seller will need more
extensive representations and warranties from the buyer.

*
A
   

The second major characteristic of merger and acquisition agreements is the addition of various pre-
closing covenants, or promises to do something, or not do something, during the period between the
signing of the acquisition agreement and the closing. Usually, covenants are absolute; nevertheless,
some may be subject to a "reasonable efforts" qualification. Other than covenants relating to corporate
approvals and governmental filings and approvals, compliance with a particular covenant may be
forewent by the party that benefits from the covenant.

There are two types of pre-closing covenants: negative covenants and affirmative covenants. Negative
covenants restrict the seller from taking certain actions prior to the closing exclusive of the buyer͛s prior
consent. Negative covenants protect the buyer from the seller taking actions prior to the closing that
change the business that the buyer expects to buy at the closing. Characteristic negative covenants
comprise:

(a) not changing accounting methods or practices;

(b) not entering into transactions or incurring liabilities outside the ordinary course of business or in
excess of certain amounts;
(c) not paying dividends or making other distributions to stockholders;
(d) not amending or terminating contracts;
(e) not making capital expenditures;
(f) not transferring assets;
(g) not releasing claims or waiving rights; and
(h) not doing anything that would make the seller͛s representations and warranties untrue.

Affirmative covenants obligate the seller or the buyer to take certain actions prior to the closing. Typical
affirmative covenants include:

(a) allowing the buyer full access to the seller͛s books, records, and other properties;
(b) obtaining the necessary board and stockholder approvals;
(c) obtaining the necessary third party consents; and
(d) making the required governmental filings and obtaining the required governmental approvals.
 

 


Merger and acquisition agreements usually also enclose numerous conditions to closing, which are
certain obligations that must be fulfilled in order to legally necessitate the other party to close the
transaction. Other than conditions to closing relating to corporate approvals and governmental filings
and approvals, acquiescence with a particular condition to closing may be waived by the party that
benefits from the condition. The interplay between pre-closing covenants and conditions to closing is
significant. If a particular matter is addressed exclusively as a covenant, the buyer͛s only remedy for the
breach of the covenant will be monetary damages. Nevertheless, if a particular matter also is addressed
as a condition to closing, the buyer can walk away from the transaction if the condition is not satisfied.
In addition, and perhaps equally as significant, the buyer may be able to use the threat of not closing as
leverage to renegotiate the terms of the transaction.

All merger and acquisition agreements present that, as a condition to closing, the representations and
warranties of the parties must be accurate and truthful at the closing, and that the pre-closing
covenants have been performed or fulfilled prior to the closing. This is in general confirmed by each
party delivering a written certificate to that effect to the other party.

Other typical conditions to closing include:

(a) receipt of the necessary third party consents;

(b) receipt of the necessary governmental approvals;
(c) receipt of legal opinions and other closing documents;
(d) receipt of certain financial statements or the achievement of certain financial milestones;
(e) receipt of employment or non-competition agreements from key employees; and
(f) satisfactory completion of the buyer͛s due diligence of the seller͛s business.

 


 

The last main characteristic of typical merger and acquisition agreements is indemnification.
Nevertheless, indemnification provisions are strange in agreements for the acquisition of a public
company. Indemnification requirements protect the parties from definite matters that occur after the
closing and allocate the risks and responsibilities for these occurrences between the buyer and the
seller. Indemnification provisions characteristically address breaches of covenants or representations
and warranties that are discovered after the closing. In addition, indemnification provisions address
items that are disclosed in the seller͛s representations and warranties and for which the seller retains
accountability after the closing. An instance is pending litigation, the outcome and amount of damages
of which cannot be predicted and reflected in the purchase price. Consequently, the buyer may need
the seller to stay responsible for the litigation after the closing. The buyer may also ask for separate
indemnification for environmental and tax liabilities beyond the seller͛s representations and warranties.

Usually, indemnification provisions are a great deal negotiated, and the seller will seek to limit its post-
closing indemnification obligations in numerous ways. First, the seller will try to limit the time period
after the closing for which it has indemnification obligations. In theory, this time period should be based
upon the reasonable period of time within which the buyer, through reasonable diligence, should have
discovered the breach and misrepresentation or, if relevant, the time period within which a third party
would make its claim. In practice, the parties usually agree on a period of one to three years after the
closing. Exceptions may be made for environmental and tax liabilities, for which the time period may be
the applicable decree of limitations.

Second, the seller will try to impose a cap on the total amount of its indemnification liability. A lot of
sellers try to cap their liability at an amount less than the total purchase price. A lot of buyers will agree
to a cap equal to the total purchase price. If the seller͛s business is "clean," the risk to the buyer in in
accord to an indemnification cap may be small.

Third, the seller will try to negotiate a "basket" or a "deductible" on its indemnification obligations in
order to get rid of small indemnification claims. A "basket" or "deductible" provides that the seller does
not have liability to the buyer until the amount of the buyer͛s losses exceed a definite amount. In the
case of a "basket," when the buyer͛s losses exceed the agreed upon "basket" amount, the seller is
legally responsible for the total amount of the losses. In the case of a "deductible," when the buyer͛s
losses go beyond the agreed upon "deductible" amount, the seller is liable only for the surplus amount
of the losses above the "deductible."

In order to make sure that there are funds available to gratify the seller͛s indemnification obligations,
the buyer may necessitate that a portion of the purchase price be held in escrow by a third party for a
period of time after the closing. On the other hand, the buyer may hold back a portion of the purchase
price and give the seller a promissory note for that portion but retain the right to offset the promissory
note to satisfy its indemnification claims.

The whole merger process is generally kept secret from the general public, and often from the majority
of the employees at the concerned companies. In view of the fact that the majority of merger attempts
do not succeed, and most are kept secret, it is difficult to presume how many potential mergers occur in
a given year. It is likely that the number is very high, nevertheless, given the amount of successful
mergers and the desirability of mergers for many companies.

A merger may be required for various reasons, some of which are advantageous to the shareholders,
some of which are not. One use of the merger, for instance, is to combine a very profitable company
with a losing company in order to use the losses as a tax write-off to offset the profits, while expanding
the corporation as a whole.
Growing one's market share is another major use of the merger, chiefly amongst large corporations. ry
merging with major competitors, a company can come to control the market they compete in, giving
them a freer hand with regard to pricing and buyer incentives. This form of merger may cause problems
when two overtopping companies merge, as it may trigger litigation concerning monopoly laws.
Another kind of popular merger brings in concert two companies that make dissimilar, but
complementary, products. This may also comprise purchasing a company which controls an asset your
company utilizes anywhere in its supply chain. Major manufacturers buying out a warehousing chain in
order to save on warehousing costs, as well as making a profit in a straight line from the purchased
business, is a good instance of this. PayPal's merger with eray is another good instance, as it allowed
eray to avoid fees they had been paying, while tying two complementary products together.
A merger is generally handled by an investment banker, who aids in transferring ownership of the
company all the way through the strategic issuance and sale of stock. Some have supposed that this
relationship causes some troubles, as it provides an incentive for investment banks to push existing
clients towards a merger even in cases where it may not be beneficial for the stockholders.
Mergers and acquisitions are means by which corporations unite with each other. Mergers take place
when two or more corporations become one. To protect shareholders, state law provides procedures
for the merger. A vote of the board of directors and then a vote of the shareholders of both
corporations is more often than not required. Subsequent to a merger, the two corporations come to an
end to exist as separate entities. In the classic merger, the assets and liabilities of one corporation are
automatically transferred to the other. Shareholders of the vanishing company become shareholders in
the surviving company or receive compensation for their shares.
Mergers may come as the consequence of a negotiation between two corporations interested in
combining, or when one or more corporations "target" another for acquisition. Combinations that
happen with the approval and encouragement of the target company's management are known
"friendly" mergers; combinations that occur despite opposition from the target company are known as
"hostile" mergers or takeovers. In either case, these consolidations can bring together corporations of
approximately the same size and market power, or corporations of vastly diverse sizes and market
power.
The term "acquisition" is normally used when one company takes control of another. This can take place
through a merger or a number of other techniques, such as purchasing the greater part of a company's
stock or all of its assets. In a purchase of assets, the transaction is one that must be negotiated with the
management of the target company. Compared to a merger, an acquisition is treated in a different way
for tax purposes, and the acquiring company does not essentially assume the liabilities of the target
company.
A "tender offer" is a most famous way to purchase a majority of shares in another company. The
acquiring company makes a public offer to buy shares from the target company's shareholders,
therefore by passing the target company's management. In order to induce the shareholders to sell, or
"tender,͟ their shares, the acquiring company characteristically offers a purchase price higher than
market value, often considerably higher. Certain situations are often placed on a tender offer, such as
necessitating the number of shares tendered be adequate for the acquiring company to gain control of
the target. If the tender offer is successful and a sufficient percentage of shares are acquired, control of
the target company through the normal methods of shareholder democracy can be taken and after that
the target company's management replaced. The acquiring company can also use their control of the
target company to bring about a merger of the two companies.
Habitually, a successful tender offer is accompanied by a "cash-out merger." The target company (now
controlled by the acquiring company) is merged into the acquiring company, and the left behind
shareholders of the target company have their shares transformed into a right to receive a certain
amount of cash.
Another ordinary merger variation is the "triangular" merger, in which an auxiliary of the surviving
company is formed and then merged with the target. This protects the surviving company from the
liabilities of the target by keeping them within the subsidiary rather than the parent. A "reverse
triangular merger" has the acquiring company make a subsidiary, which is then merged into the target
company. This form preserves the target company as a continuing legal entity, though its control has
passed into the hands of the acquirer.
Usually, mergers and other sorts of acquisitions are performed in the hopes of realizing an economic
gain. For such a transaction to be justified, the two firms concerned must be worth more together than
they were apart. Some of the potential benefits of mergers and acquisitions comprise attaining
economies of scale, combining complementary resources, garnering tax advantages, and eliminating
inefficiencies. Other reasons for bearing in mind growth through acquisitions comprise getting
proprietary rights to products or services, increasing market power by purchasing competitors, shoring
up weaknesses in key business areas, penetrating new geographic regions, or providing managers with
new opportunities for career growth and advancement. Since mergers and acquisitions are so
compound, nevertheless, it can be very complicated to evaluate the transaction, define the related costs
and benefits, and handle the resulting tax and legal issues.
When a small business owner opts to merge with or sell out to another company, it is at times called
"harvesting" the small business. In this condition, the transaction is anticipated to release the value
locked up in the small business for the benefit of its owners and investors. The thrust for a small
business owner to pursue a sale or merger may comprise estate planning, a requirement to diversify his
or her investments, a failure to finance growth independently, or a simple need for change.
Furthermore, some small businesses find that the best way to grow and compete against larger firms is
to merge with or acquire other small businesses.
Principally, the decision to merge with or acquire an additional firm is a capital budgeting decision much
like any other. rut mergers vary from ordinary investment decisions in at least five ways. First, the value
of a merger may depend on such things as strategic fits that are hard to measure. Second, the
accounting, tax, and legal aspects of a merger can be complex. Third, mergers often involve issues of
corporate control and are a means of replacing existing management. Fourth, mergers clearly affect the
value of the firm, but they also affect the relative value of the stocks and bonds. Lastly, mergers are
often "unfriendly."
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The main advantages from mergers and acquisitions can be listed as increased value generation,
increase in cost efficiency and increase in market share.
Mergers and acquisitions often lead to an increased value generation for the company. It is anticipated
that the shareholder value of a firm after mergers or acquisitions would be bigger than the sum of the
shareholder values of the parent companies.
An increase in cost efficiency is exaggerated through the procedure of mergers and acquisitions. This is
for the reason that mergers and acquisitions lead to economies of scale. This in turn promotes cost
efficiency. As the parent firms amalgamate to form a larger new firm the scale of operations of the new
firm increases. As output production rises there are chances that the cost per unit of production will
come down.



Demergers are circumstances in which divisions or subsidiaries of parent companies are split off into
their own independent corporations. The process for a demerger can differ somewhat, depending on
the reasons behind the implementation of the split. Usually, the parent company maintains some
degree of financial interest in the newly formed corporation, although that interest may not be enough
to uphold control of the functionality of the new corporate entity.

It results in the transfer by a company of one or more of its undertakings to one more company. The
company whose undertaking is transferred is known as the demerged company and the company (or
the companies) to which the undertaking is transferred is referred to as the resulting company.

A demerger may take the form of -

! A spinoff or a split-up.
  

 



 ! Joint ventures
! Sell off and spin off
! Divestitures
! Equity carve out
! Leveraged buy outs (LrO)
! Management buy outs
! Master limited partnerships
! Employee stock ownership plans (ESOP)
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Joint ventures are new-fangled enterprises owned by two or more participants. They are
characteristically created for special purposes for a limited duration. It is a mixture of subsets of assets
contributed by two (or more) business entities for a explicit business purpose and a limited duration.
Each of the venture partners continues to exist as a separate firm, and the joint venture represents a
new business enterprise. It is a agreement to work together for a period of time each participant
expects to gain from the activity but also must make a contribution.
  
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! Construct on company's strengths

! Spreading costs and risks
! Improving way in to financial resources
! Economies of scale and benfits of size
! Right of entry to new technologies and customers
! Right of entry to innovative managerial practices


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! To supplement inadequate financial or technical ability to enter a particular line or business.

! To share technology and generic management skills in organization, planning and control.
! To diversify risk
! To attain distribution channels or raw materials supply
! To attain economies of scale
! To make bigger activities with smaller investment than if done separately
! To take advantage of favorable tax treatment or political incentives (particularly in foreign
ventures).
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If a corporation lends a patent technology to a Joint Venture, the tax effects may be less than on
royalties earned though a licensing arrangements.

 
 -
One partner leads the technology, while another leads depreciable facilities. The depreciation offsets
the revenues falling to the technology. The J.V. may be taxed at a lower rate than any of its partner and
the partners pay a later capital gain tax on the returns realized by the J.V. if and when it is sold. If the J.V.
is organized as a corporation, only its assets are at risk. The partners are responsible only to the extent
of their investment, this is chiefly significant in hazardous industries where the risk of workers,
production, or environmental liabilities is high.
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Spinoffs are a way to eliminate the underperforming or non-core business divisions that can pull down
profits.






1. The company determines to spin off a business division.

2. The parent company files the essential paperwork with the Securities and Exchange roard of the
Country.
3. The spinoff becomes a company of its own and must also file paperwork with the Securities and
Exchange roard of the country.
4. Shares in the new company are distributed to parent company shareholders.
5. The spinoff company goes public.
Take in considerations that the spinoff shares are disseminated to the parent company shareholders.
There are two reasons why this creates value:
1. Parent company shareholders infrequently want anything to do with the new spinoff. After all,
it's an underperforming division that was cut off to get better the bottom line. As a
consequence, several new shareholders sell right away after the new company goes public.
2. rig institutions are often prohibited to hold shares in spinoffs due to the smaller market
capitalization, increased risk, or poor financials of the new company. Consequently, a lot of large
institutions automatically sell their shares directly after the new company goes public.
Trouble-free supply and demand logic says us that such great number of shares on the market will
obviously decrease the price, even if it is not basically justified. It is this temporary mispricing that gives
the enterprising investor an opportunity for profit.
There is no money transaction in spin-off. The transaction is treated as stock dividend and tax free
exchange.

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Is a transaction in which some, but not all, parent company shareholders take delivery of shares in a
subsidiary, in return for dispensing with their parent company͛s share.
In other words some parent company shareholders take delivery of the subsidiary͛s shares in return for
which they must give up their parent company shares.
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A segment of existing shareholders receives stock in a subsidiary in exchange for parent company stock.
ã
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Is a transaction in which a company spins off all of its subsidiaries to its shareholders & ceases to exist.
! The entire firm is broken up in a series of spin-offs.
! The parent no longer exists and
! Only the new offspring survive.
In a split-up, a company is split up into two or more independent companies. As a continuation, the
parent company vanishes as a corporate entity and in its place two or more separate companies come
forth.
ã%+A: the elimination of minority shareholders by controlling shareholders.

ã
Selling a part or all of the firm by any one of means: sale, liquidation, spin-off and so on. Or General term
for divestiture of part/all of a firm by any one of a no. of means: sale, liquidation, spin-off and so on.
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! A partial sell-off/slump sale, comprises the sale of a business unit or plant of one firm to an
additional firm.
! It is the mirror image of a purchase of a business unit or plant.
! From the seller͛s perspective, it is a form of contraction; from the buyer͛s point of view it is a
form of expansion.

 


 

! Raising capital
! Curtailment of losses
! Strategic realignment
! Efficiency gain.
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Divesting a subsidiary can achieve a variety of strategic objectives, such as:
! Anti-trust ʹ rreak up a business in response to anti-trust concerns.
! Corporate defense ʹ Divest "crown jewel" assets to make a hostile takeover of Parent Company
less attractive.
! Eliminating dissynergies ʹ Reduce bureaucracy and give Spin Company management complete
autonomy.
! Institutional sponsorship ʹ Promote equity research coverage and ownership by sophisticated
institutional investors, either of which tend to validate SpinCo as a standalone business.
! Motivating management ʹ Improve performance by better aligning management incentives
with Spin Co͛s performance (using Spin Co͛s, rather than Parent Company, stock-based awards),
creating direct accountability to public shareholders, and increasing transparency into
management performance.
! Public currency ʹ Create a public currency for acquisitions and stock-based compensation
programs.
! Undiversification ʹ Divest non-core businesses and sharpen strategic focus when direct sale to a
strategic or financial buyer is either not compelling or not possible
! Unlocking hidden value ʹ Establish a public market valuation for undervalued assets and create
a pure-play entity that is transparent and easier to value

 

 
Divesture is a transaction through which a firm sells a portion of its assets or a division to a different
company. It comprises selling some of the assets or division for cash or securities to a third party which
is an outsider.
Divestiture is a form of narrowing for the selling company and means of expansion for the purchasing
company. It represents the sale of a division of a company (assets, a product line, a subsidiary) to a third
party for cash and or securities.

Mergers, assets purchase and takeovers lead to expansion in some way or the other. They are
established on the principle of synergy which says 2 + 2 M 5! , divestiture on the contrary is based on the
principle of ͞anergy͟ which says 5 ʹ 3 M 3!.
Among the different techniques of divestiture, the most significant ones are partial sell-off, demerger
(spin-off & split off) and equity carve out. Some authors define divestiture rather scarcely as partial sell
off and some scholars define divestiture more generally to comprise partial sell offs, demergers and so
on.


   i



! Antitrust
! Change of focus or corporate strategy
! Defend against takeover
! Good price.
! Need cash
! Sale to pay off leveraged finance
! Unit unprofitable can mistake
"%

A

A transaction in which a parent firm extends some of a subsidiaries common stock to the general public,
to bring in a cash infusion to the parent with no loss of control.
Put differently equity carve outs are those in which some of a subsidiaries shares are offered for a sale
to the general public, bringing an infusion of cash to the parent firm with no loss of control.
Equity carve out is also a means of reducing their exposure to a riskier line of business and to boost
shareholders value.
h 
 
!
  
 R

! A new control group is immediately created.
! A new legal entity is created.
! It is the sale of a minority or majority voting control in a subsidiary by its parents to outsider
investors. These are also referred to as ͞split-off IPO͛s͟
! The equity holders in the new entity need not be the same as the equity holders in the original
seller.
Difference between Spin-off and Equity carve outs:
1. In a spin off, distribution is made pro rata to shareholders of the parent company as a dividend,
a form of non cash payment to shareholders
1. In equity carve out; stock of subsidiary is sold to the public for cash which is received by parent
company
2. In a spin off, parent firm no longer has control over subsidiary assets.
In equity carve out, parent sells only a minority interest in subsidiary and retains control.
 


*
 


Master Limited Partnership͛s are a kind of limited partnership in which the shares are openly traded.
The limited partnership interests are divided into units which are traded as shares of common stock.
Shares of ownership are called as as units.
MLPs usually operate in the natural resource (petroleum and natural gas extraction and transportation),
financial services, and real estate industries.
The benefit of a Master Limited Partnership is it combines the tax benefits of a limited partnership (the
partnership does not pay taxes from the profit - the money is only taxed when unit holders obtain
distributions) with the liquidity of a openly traded company.
There are two types of partners in this type of partnership:
1. The limited partner is the person or group that provides the capital to the MLP and
receives periodic income distributions from the Master Limited Partnership's cash
flow
2. The general partner is the party responsible for managing the Master Limited
Partnership's affairs and receives compensation that is linked to the performance of
the venture.

" ã
 * ("ã*)

An Employee Stock Option is a kind of defined contribution benefit plan that buys and holds stock. ESOP
is a qualified, defined contribution, employee benefit plan designed to invest first and foremost in the
stock of the sponsoring employer.
Employee Stock Option͛s are ͞qualified͟ in the sense that the ESOP͛s sponsoring company, the selling
shareholder and participants receive a variety of tax benefits.
With an ESOP, employees never buy or hold the stock directly.
h
 
! Employee Stock Ownership Plan (ESOP) is an employee benefit plan.
! The scheme provides employees the ownership of stocks in the company.
! It is one of the profit sharing plans.
! Employers have the benefit to use the ESOP͛s as a tool to fetch loans from a financial institute.
! It also provides for tax benefits to the employers.
        : increased cash flow, tax savings, and increased productivity from highly
motivated workers.
      
: is the ability to share in the company's success.
#'
'
 B
! Organizations strategically plan the ESOPs and make arrangements for the purpose.
! They make annual contributions in a special trust set up for ESOPs.
! An employee is eligible for the ESOP͛s only after he/she has completed 1000 hours within a year
of service.
! After completing 10 years of service in an organization or reaching the age of 55, an employee
should be given the opportunity to diversify his/her share up to 25% of the total value of ESOP͛s.


"""9" * "ã "."㢢<cãã( ,¢)¢9"ã

c
ã ¢



Various major merger movements have taken place in the United States and each was more or less
dominated by specific kind of merger. All of the merger movements occur when the economy
experienced constant high rate of growth and conceded well particular development in business
environments.
1895-1904 movements: the combination movement at the turn of the century constitutes chiefly of
horizontal mergers, which resulted in high concentration in many industries; as well as heavy
manufacturing industries. The period was one of rapid economic expansion. The movements peaked in
1899 and almost ended in 1903, when a severe economic recession set in mergers completed in the
period 1887 through 1904 were estimated to involve 15 %of the total numbers of plants and employees
comprising manufacturers in 1900 (Markhar, 1955).

The mergers of 1895-1904 followed by major changes in economic infrastructure and production
technologies. The period was accompanied by the completion of the transcontinental railroad system,
the advent of a national economic market and thus, making the way for regional firms becoming
national firms (Markhan, 1955 Salter and Weinhold, 1980). While the preceding argument by Markhan
does mergers some economists cast doubt on the possibility that large scale production was a motive to
combination. Lynch points out three problems in economy of scale national.

(A) although scale economics can be more simply attained in combination of small firms than of
large firms; the merger activity was concentrated in the large-firm category. Nevertheless,
Markhan notes that nearly all the tabulation of early mergers were based on large mergers and
did not comprise merger comprising a capitalization of less then $1 million (Markhan, 1955).
(r) Lynch͛s second point is that combinations resulted in multi plant operations but scale economics
are obtained when production is integrated by investments in large replacement facilities.
Clearly, horizontal combination between geographically estranged plants will not have any
production economics of scale in the absence of their physical integration. Nevertheless,
economics of scale can exist not only in production but also in administration and marketing.
(C) Finally, lynch observe that merger activity in the early period occurred in a wide range of
industries and technological advancements motivating horizontal mergers cannot surface in a
number of industries with in a short time span. This appears to miss the point that economies of
scale available not shape technological advancements in individual industries but rather became
attainable from the reduction in transportations costs, whose impact could have been
pervasive.

"


Since the middle 1950s a wave of takeovers, historically unprecedented in its scope, and its effects had
swept through rritish industry. In a study of UK manufacturing industries by Ajit Singh (1971), it was
found that 2,126 firms engaged in manufacturing, which were quoted on the U.K. stock exchanges in
1954; more than 400 had been acquired by 1960. Out of the next 100 large firms in 1954, 10 were taken
over during the next 6 years. The number of unquoted manufacturing companies and other smaller
concerns acquired in the same period runs into thousands. This take over movement has been far larger
than those which occurred at the turn of the century and in the early 1920s.

The reasons for the enormous volume of acquisitions in the 1980s were manifold. The stock market in
the UK, in harmony with markets in other countries, experienced a strong bull phase while culminated
as the October crash of 1987, there was a mire relaxed, laissez-faire governmental attitude to mergers
and acquisitions embodied in the new vision of Thatcherism. The 1980s also witnessed divestments on a
large scale.

The simultaneous increase in acquisitions and divestments suggest a considerable amount of corporate
restructuring in the UK economy in recent years. Such restructuring has been made possible by new
organizational innovations like, leveraged buyouts, management buyout (Sudersan 1995).

Even though Taggarts͛ figure does not cover the period from 1987 to the present, junk financing was
certainly curtailed by market conditions starting in late 1989. Even if junk bonds did not play a major
role in the 1980s mergers deals, the dramatic increase in corporate leveraging during the 1980s served
to deteriorate the quality of debt worldwide especially when coupled with high interest rates supported
by governments contending with inflation caused by increase lightly, itself due in part to more lending
and easier consumer credit. This has led to the highest levels of foreclosure and bankruptcies since the
great depression in the 1930s.

#""ãh ,¢¢9"ã

There is a very old and ongoing debate concerning firms͛ motives for engaging in mergers and
acquisitions. Neoclassical theories depict collective merger activity as firms͛ value-enhancing response
to industry-wide and/or economy-wide shocks. rehavioral and agency theories, on the other hand, view
M&A͛s as the resulting from investors͛ and/or managers͛ cognitive biases, or the inherent conflicts of
interests between managers and investors. Some significant empirical aspects of the aggregate merger
activity are widely accepted: mergers occur in waves; within each wave, they tend to cluster by industry;
and, within industries, higher merger activity is associated with larger positive or negative shocks.
Nevertheless, why these patterns emerge remains an open question.

The majority of existing theories of merger timing come out from completion in product markets. In this
section we explore the impacts of product market competition and industry structure on firms͛
incentives to connect in horizontal mergers and on the consequential dynamics of mergers. Ceteris
paribus, a horizontal merger gains the combined value of the merging firms, due to the post-merger
collusion in output markets. Nevertheless, the reduced level of competition following a merger also
attracts new firms to enter the industry. Possible entry, in turn, minimizes the value of the officeholders
and their incentives to merge. When an industry is in expansion, the value of the entry option is high in
spite of of the industry structure, and the incumbents cannot deter entry by not merging. When an
industry is in decline, entry is unbeneficial in spite of of the incumbents͛ decision whether to merge.
Therefore, in the extreme states of demand, the incumbents͛ merger decision has limited effect on the
entrant͛s decision, and the effect of higher incumbents͛ profits due to the post-merger collusion
dominates the merger decision. In intermediate states, the merger decision has a extra marked effect on
the likelihood of potential entry, and the incumbents may be better off not merging in order to delay
entry. The reason above suggests that as a result of the interaction between incumbents͛ decision to
merge and new firms͛ decision to enter an industry, horizontal mergers should occur with greater
frequency during periods of extreme growth or decline in demand in comparatively intense industries.
There exists a considerable body of empirical proof reliable with the two main driving forces in our
model: mergers increase incumbent firms͛ market power and they may make possible entry by
outsiders. For instance, Akhavein, rerger, and Humphrey (1997) and Prager and Hannan (1998)
document that mergers between banks lead to greater than before market power and lower deposit
interest rates. rorenstein (1990), Kim and Singhal (1993), and Singhal (1996) report alike evidence for
the airline industry. A clinical study of acquisitions in the microfilm industry by rarton and Sherman
(1984) provides evidence of important post-merger price increases. In addition, the effect of mergers on
the incentives of new firms to enter an industry is not only a clear result of an oligopolistic competition
model, but also a matter of explicit consideration by Antitrust authorities for the period of merger
application reviews. rerger, ronime, Goldberg, and White (2004) and Seeling and Critchfield (2003) find
that mergers induce entry in the banking industry. As a result, it seems sensible that strategic
considerations may effect firms͛ incentives to merge and the resulting dynamics of horizontal mergers.

One proposition of the existing models of merger timing is that firms͛ incentives to merge in periods of
economic recession are diverse from those in periods of expansion. Lambrecht (2004) examines mergers
motivated by operating synergies. In his model, mergers are likely to occur in expansions. In Lambrecht
and Myers (2007), takeovers give out a mechanism to force disinvestment in declining industries. Their
arguments lead to takeover transactions occurring mostly in industries that have experienced negative
economic shocks. Similarly, in Mason and Weeds (2006) mergers in expansions are motivated by
production synergies, while those in recessions allow consolidation and disinvestment. We show that in
oligopolistic industries, strategic considerations increase the likelihood of observing horizontal mergers
both in periods of rising and declining demand and that strategic incentives to attempt or delay
horizontal mergers are more significant in more concentrated industries.

To highlight the effect of strategic considerations on the relation between the state of industry demand
and takeover activity, in the base model we deliberately focus on the strategic aspects and abstract from
other significant motives for merging. Strategic considerations, nevertheless, are but one of numerous
factors that may affect firms͛ decision to merge. Specifically, we do distinguish that assuming no
production synergies, no merger costs, no operating leverage, and duopolistic competition may create
overly stylized results. For that reason, we also discuss the intuition behind a number of extensions of
the base model that relax these assumptions. These extensions show that strategic considerations carry
greater weight in firms͛ merger decisions when the costs of merging, operating synergies, and operating
leverage are comparatively low, and when the degree of industry attentiveness is relatively high.
Our theory is strongly related to recent models incorporating product market competition into the
analysis of merger dynamics (e.g., Lambrecht (2004), Hackbarth and Miao (2007), and Yan (2006)). Our
contribution to this literature is screening that the threat of potential entry is a crucial determinant of
the dynamics of mergers, while entry is not allowed in existing models. Our model is also related to
studies that examine entry into an industry within a dynamic setting (e.g., Dixit (1989), raldursson
(1998), Grenadier (2002), Fries, Miller and Perraudin (1997), Lambrecht (2001), and Zhdanov (2007)).
We put in to the dynamic entry literature by incorporating the option of a merger initiated by incumbent
firms. In addition, our analysis is related to studies that examine the link between incumbents͛
incentives to merge and outsiders͛ incentives to enter the industry (e.g., Cabral (2003), Marino and
Zábojník (2006), Toxvaerd (2008), and Werden and Froeb (1998)). We contribute to this literature by
examining the timing of mergers in the presence of potential entry in rising and declining industries.
The difficulty we examine is by its very nature dynamic, for the reason that a key driver of the relation
between demand shocks and mergers in the model is the impact that mergers have on the timing of
future entry. We rely on a continuous-time real options framework to typify the dynamics of both
mergers and entry, for the reason that this approach results in time-independent equilibria and, thus, is
more logically well-mannered than a finite-period dynamic game. In addition, employing a framework
similar to that of other recent models of merger timing (e.g., Lambrecht (2004), Lambrecht and Myers
(2007), Hackbarth and Morellec (2007), Morellec and Zhdanov (2005, 2008), Leland (2007), and
Hackbarth and Miao (2007) among others) allows us to straighten out the effects of product market
interaction on the timing of mergers from other, non-product-market-related effects.
We donate to the empirical merger literature by showing, using parametric and semi-parametric tests,
that a significant reason for the U-shaped relation between economic shocks and merger intensity,
recognized in Mitchell and Mulherin (1996), Andrade and Stafford (2004), and Harford (2005), is the
effect of demand shocks on firms͛ incentives to merge horizontally. In addition, the evidence shows that
the U-shaped relation between horizontal merger concentration and the state of industry demand is
there in relatively concentrated industries, whereas it is absent in relatively competitive ones, in which
strategic considerations are likely to play a smaller role. This confirmation is reliable with our model,
which predicts that, ceteris paribus, horizontal mergers within oligopolistic industries are more probable
to take place in times of high and low demand relative to times of intermediate demand, and that such
pattern disappears within relatively competitive industries.
 
ã

  -:
There are two incumbents in the industry. Each incumbent is endowed with capital, 4. Moreover, entry
by one firm is allowed, with an equal amount of capital, 4. The firms͛ production functions are of the
Cobb-Douglas specification with two factors and constant returns to scale:

   $ 1
|


|
(1)

Where  is the firm ͛s output, and  is the amount of labor it employs.

The cost of one unit of labor per unit of time is denoted . The amount of capital is fixed, hence labor is
the only variable input. At any given instant, each firm can costlessly adjust its labor input to produce
any output quantity. Since firms are not able to alter the level of capital, firm ͛s instantaneous variable
cost of producing  units is

$

 $      (2)

Note that this specification assumes away technological (production) synergies.

  1

The firms are subject to heterogenous-products rertrand competition.

The heterogeneous-products rertrand competition allows us to accommodate different degrees of

substitutability among the rivals͛ products and analyze comparative statistics with respect to the extent
of competition. The logic and results of the model, nevertheless, are robust to choosing different types
of product market competition.

  '

The demand-side of the industry is characterized by a representative consumer with quadratic

instantaneous utility function


| 
c $  
Þ $
Þ$

È
V Þ $ $ 
(3)
|
 |  

Where ɲ, ɴ, and ɶ are the parameters of the utility function,  is (annualized) consumption of good ,  is
the number of active firms in the industry and, thus, the number of available products, and ! is the
stochastic shock to the representative consumer͛s utility. This specification of the utility function is
typical of partial equilibrium models commonly used in the industrial organization literature. We further
assume that ! follows a geometric rrownian motion

 )   È Ä  

Where, Ä is a standard Wiener process on a filtered probability space (ɏ, , ).

We impose the standard conditions: ɲ > 0 and ɴ > ɶ > 0. ɶ > 0 implies that the goods produced are
substitutes, which is reasonable for products of firms competing in the same industry. ɲ> 0 and ɴ > ɶ
imply that the utility function is concave in each of its arguments. The specific functional form of the
relation between the representative agent͛s utility and the state of the stochastic shock, !, is made for
analytical convenience. It is common in the industrial organization literature to assume that shocks to
demand correspond to changes in the intercept of the demand function. Consistent with this norm, as
shown below, the term  in the linear term of the utility function translates into a linear relation
between  and the intercept of the demand function. This in turn, translates into a linear between !
and firms͛ instantaneous profits.

Equating the marginal utility that the representative consumer derives from consuming product  to its
price and solving the resulting system of  equations in  unknowns (quantities) defines the demand
function for product  as a function of ͛s own price and the other products͛ prices:

i     


 Þ   (4)
=

Where


 
h
 # |V
h
 #
V

 (5)
 h
 # |V  h # V 
V

 h
 # |V  h # V 

As mentioned above, the only benefit of merging in the base-case model is that the incumbents can
coordinate their pricing strategies. The entrant benefits from the merger, due to the lower level of
competition. This leads to the following intuitive results.

' &

(i) The combined instantaneous profit of the two incumbents is higher if they merge than if
they stay separate, ceteris paribus.
(ii) The entrant͛s instantaneous profit is higher if the two incumbents merge than it they stay
separate ceteris paribus.
(iii) The incumbents͛ combined instantaneous profit is higher in the case of no merger and no
entry than in the case of merger and entry.

When the two incumbents merge, they charge higher prices for the reason that they internalize the
cannibalization effect of raising one product͛s price on the quantity sold of the other product. This
benefits the entrant and increases its instantaneous profit. Combining the first and third parts of Lemma
1 results in the following set of relations for the combined instantaneous profits of the incumbents in
the four possible scenarios (merger/no merger combined with entry/no entry):

@      @      @     @      (6)

This result is significant. The first and third inequalities show that given the presence/absence of the
entrant in the industry, the incumbents are always better off merging (part (i) of Lemma 1). The second
inequality (part (iii) of Lemma 1) is at the heart of our analysis and implies that the incumbents may be
better off not merging, if by staying separate they can deter potential entry of the new firm in the
industry.

Absent the threat of new entry, the optimal strategy of the incumbents is to initiate a merger attempt
independent of the state of the industry demand, for the reason that it is costless to do so. The threat of
potential entry makes the problem more realistic and interesting, by introducing an opportunity cost the
incumbents must bear when attempting a merger. On the other hand, the entrant͛s profit and thus, its
decision to enter depends on whether the incumbents have merged.

¢ 
 3
Incumbent firms are endowed with an option to initiate one attempt to merge with each other
(combine operations). Attempting and implementing merger among incumbents entails no out-of-
pocket costs.

Once initiated, the merger attempt is successful with probability < 1.

The assumption that a merger attempt does not necessarily result in a successful merger is consistent
with the empirical evidence. First, a merger attempt can be unsuccessful due to difficulties in the
negotiation process. Anti-takeover provisions, such as staggered boards, limits to shareholder bylaw
amendments, poison pills, golden parachutes, supermajority requirements, and state anti-takeover
legislation reduce the likelihood of successful merger attempts. roone and Mulherin (2007) report that
only 27% of potential bidders that sign a confidentiality agreement and only 78% of bidders that submit
a private written offer succeed in acquiring their target. Second, even when the firms involved are
willing parties to the negotiation, antitrust authorities may oppose the transaction on anticompetitive
grounds or provide conditional approval, requiring firms to divest the operations that pose the highest
anti-competitive threat. This, of course, is an aspect that is particularly relevant in the context of our
model. In Eckbo͛s (1983) sample of 191 horizontal mergers that occurred between 1963 and 1978, for
instance, 65 were challenged by either the Justice Department or the Federal Trade Commission.

Finally, even if the merger deal is successfully completed, there remains uncertainty about the ability of
the merging firms to successfully integrate their operations. Mitchell and Lehn (1990) and Lehn and
Zhao (2006) show that there are badly conceived mergers that are subsequently thwarted through
divestitures, bust-up takeovers, and management turnover. There is also anecdotal evidence that
suggests that post-merger successful integration turnover. There is also anecdotal evidence that
suggests that post-merger successful integration is far from being certain.

The assumption that the two incumbents are endowed with only one option to initiate a merger
attempt is made for analytical tractability. From the modeling perspective, allowing multiple merger
attempts is equivalent to raising the probability of merger success, . In the base model, for the reason
that we assume merging entails no out of pocket costs, allowing a finite number of merger attempts
would result in a series of attempts that would stop either after a successful merger or after all attempts
have been exhausted. Uncertainty about the success of the merger attempt is crucial in our model. This
is for the reason that absent uncertainty, entry is independent of the merger attempt and vice versa,
which makes mergers optimal in all states of world.

¢ 
 1

Upon successful consummation of the merger, the shareholders of each incumbent receive a 50% stake
in the merged entity. We abstract from the analysis of how merger gains are allocated. All that is
required for a deal to take place is that the combined value of the merging firms increases as a result of
a merger. For the reason that the two incumbents are identical in all respects, we simply assume that
the gains are split evenly between the merging firms to ensure that the merger is desirable for both sets
of shareholders. Moreover, in our model the merger payment method (cash or stock) is irrelevant, as
long as capital markets are efficient and securities are correctly priced. Therefore, we do not analyze
misvaluation-driven merges, as in Rhodes-Kropf and Viswanathan (2004) or in Shleifer and Vishny
(2003).
¢ 
 8
Entry requires the outsider to incur a fixed irreversible cost, O, to obtain capital 4. This assumption
precludes immediate entry for low realizations of the demand shock. Consistent with economic
intuition, the 1997 Horizontal Mergers Guidelines highlight that costless entry precludes mergers
motivated by the pursuit of market power. Given that strategic (marketͶpower-related) considerations
are the focus of our analysis, we assume entry is indeed costly.
¢ 
 7
We normalize the amount of installed capital of each firm, 4, the cost of labor, , and the coefficient on
the quadratic term of the utility function, ɴ, to one. This assumption is made for analytical convenience
only. Normalizing ɴ to one is innocuous. In addition, it is straightforward to show that the general
version of the model with 4 and  that are different from one produces the same conclusions as the
more restrictive model we are examining here.

¢ 

We now proceed to the formal analysis of the model. In what follows, we incorporate the derivations of
the firms͛ instantaneous profits under different industry structures, found in the proofs of Lemma 1, and
introduce the following simplifying notation for the firms͛ instantaneous profits under different
scenarios:



   
 
|
      

# V

(7)

 /
V # V 
|


@    @      (8)

 /
È V 
|

/ È V # V


È V #
V

@    @     (9)

 /| È V 
= È /V # XV
È
V  

|

| È V | È V # V

@    @     (10)



È V 

 |

| È V | È V # V

@   @     (11)


È V 

 |



È V
| È V # V

@   @    (12)
 | È V = È /V # XV
È
V  

We start by establishing the optimal thresholds !
 and !
, corresponding to the cases in which the
incumbents have already attempted a merger, either successfully or not.
4
If the incumbents have already exercised their option to attempt a merger and have not succeeded,
then the optimal entry threshold is given by
|   # ) 
   
(13)
| #| @  
|

Where ɴ1 is the positive root of the quadratic equation  h  h # |
h #   


 |   |  

h|  #

 #


(14)


  
If the incumbents have successfully merged, then the optimal entry threshold is
|  
) 
   (15)
|
|

@  
As argued above, in order to find ! and ! we need to examine the incumbents͛ and entrant͛s
optimization programs simultaneously. The following two results provide a set of equations that
determine the solution to the entrant͛s and incumbents͛ optimization problems.
6
If ! < ! < ! then the entrant͛s value is given by
2    
  | È 
(16)
Where A and r are constants to be determined below, and ɴ2 is the negative root of the quadratic



equation Ä  # | È )
 




| )  | ) 








È
(17)

Ä 
Ä  Ä
The following conditions must hold at ! and !:
 |

È 


|
 @  


È |
 @  



 (18)


)
|
h| 
h| |
h

h
|     


|     

  (19)
 
and
 
È 
 


|
 @  

     

  È |
   
|
 @  

-    

 

|

       
(20)
  
)      
) 
Equations (18) and (20) are the value-matching conditions, which stipulate that the values of the entrant
at the two merger thresholds are exactly equal to their respective expected post-merger-attempt
values. (These values are the weighted averages of the values conditional on a successful and
unsuccessful merger attempts.) Equation (19) is the smooth-pasting condition that ensures the
optimality of the outsider͛s entry decision.
Lemma 3 provides us with three equations in four unknowns (two constants, A and r, and the optimal
merging thresholds, ! and !). Thus, we need additional conditions in order to solve for the optimal
merging thresholds. The remaining conditions come from the optimization program of the incumbents.
These conditions are derived as follows.
3
If ! < ! < ! then the value of each incumbent is given by
    
     
i
h|
 h

(21)
 
Where C and D are constants to be determined together with A, r, !, and !. The following conditions
must hold at the upper and lower merging thresholds, ! and !:
 h|     

h


i





  

h|

(22)
|   
  

|      

  Y 
      


        

   

    


 |

È 
È
@     |    | 
9    Y@  
@      È @   
È

) 
)    

  (23)
  
È |
    |
Y@
@      È @    
:
  

   

    |  h  h |
| 
h| h |
h
i h |   
|

9  | h Y        
  


           |


(24)
 h|  h | | 

|    h
        
 
:
        

      

   

In (21) the term  refers to the present value of each incumbent͛s perpetual entitlement to

instantaneous profits if the incumbents never merge and the outsider never enters. The remaining

terms, Y | È 
, account for the change in each incumbent͛s value due to the incumbent͛s option
to merge among themselves and for the threat of new entry.
Equations (22) and (23) are the value-matching conditions for each incumbent͛s optimization problem,
while (24) is the smooth-pasting condition that must obtain at the lower merging threshold. The first
term on the right-hand side in (22) is the post-merger value of an incumbent if the merger attempt is
successful, and the second term is the value of the incumbent in case of an unsuccessful merger
attempt. Note that the expression on the right hand side of (22) (unlike that of (18)) accounts for the
fact that the merger attempt would actually precede entry, so the new entrant is able to postpone entry
if the merger attempt is unsuccessful. On the contrary, (18) does not have the same term on the right
hand side for the reason that the upper merger threshold is determined as the one that makes entry
optimal even if the potential entrant cannot anticipate the result of the merger attempt.

.  "¢" "."ã
According to the definition, a conglomerate merger is a kind of merger whereby the two companies that
merge with each other are implicated in different types of businesses. The significance of the
conglomerate mergers lies in the fact that they help the merging companies to get better.

  
 


There are two major types of conglomerate mergers ʹ the pure conglomerate merger and the mixed
conglomerate merger. The pure conglomerate merger is one where the merging companies are doing
businesses that are completely unconnected to each other.
The mixed conglomerate mergers are ones where the companies that are merging with each other are
doing so with the key reason of gaining access to a wider market and client base or for intensifying the
range of products and services that are being supplied by them.
There are also a number of other subsections of conglomerate mergers like the financial conglomerates,
the concentric companies, and the managerial conglomerates.

   
 


There are more than a few reasons as to why a company may go for a conglomerate merger. Among the
more general reasons are adding to the share of the market that is owned by the company and putting
its feet into cross selling. The companies also look to add to their overall synergy and productivity by
adopting the method of conglomerate mergers.

r 
  
 


There are numerous benefits of the conglomerate mergers. One of the major advantages is that
conglomerate mergers help out the companies to diversify. As a result of conglomerate mergers the
merging companies can also bring down the levels of their exposure to risks.



  
 


There are numerous implications of conglomerate mergers. It has often been seen that companies are
going for conglomerate mergers in order to increase their sizes. Nevertheless, this also, at times, has
unfavorable effects on the functioning of the new company. It has usually been observed that these
companies are not able to perform like they used to before the merger occurred.
This was obvious in the 1960s when the conglomerate mergers were the common trend. The term
conglomerate mergers also entails that the two companies that are merging do not even have the same
customer base as they are in completely dissimilar businesses.
It has usually been seen that a lot of companies that go for conglomerate mergers are able to manage a
broad diversity of activities in a particular market. For instance, these companies can carry out research
activities and applied engineering processes. They are also able to add to their production as well as
make stronger the marketing area that makes sure of better profitability.
It has been seen from case studies that conglomerate mergers do not have an effect on the structures of
the industries. Nevertheless, there might be important impact if the acquiring company happens to be a
leading company of its market that is not concentrated and has a large quantity of entry barriers.

*¢".9"¢"

Corporate governance came out as an issue of international concern and argumentative discussion in
the early 1980s, through 1990s and this has continued into the twenty-first century. Corporate
governance is not new; it has existed while the incorporation of business began (Vinten, 2003). The
recognition of the centrality of major enterprises in allocating resources in the economy underlies
contemporary debates about corporate governance. Nevertheless, ideas about the concept of corporate
governance date back to 1776 (Tricker, 2000; Denise, 2001) when Smith, in The Wealth of Nations,
raised the issue of a lack of incentives on the part of directors to look after other people͛s money with as
much care as the owners themselves would:

 


    
  
 

  



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Smith did not use the word corporate governance;
the term only emerged in the 1980s (Tricker, ͞Good corporate governance practices instill in
2000). Nevertheless, this remark shows that he companies the essential vision Processes and
had a sound understanding of the issue of structures to make decisions that ensure longer-
corporate governance: when the owners of a term sustainability. More than ever we need
corporation are dissimilar from those who companies that can be profitable as well as
manage it, incentive problems tend to occur. The achieving environmental social and economic
nature of the debate on corporate governance is value of society.͟
prejudiced by the way in which corporations are á
 4
Ͷ Vice President rusiness Advisory
viewed. Clarke and Clegg (1998) challenge that Services IFC
the early conceptualisation of corporations tended to treat corporations as the property of equity
capital providers (shareholders) for the pursuance of their economic interests. Nevertheless, a necessary
characteristic of a corporation is its ability to have a split existence apart from those who own it. When a
corporation has attained its own different and unique existence, the issue of control arises.
Mintzberg (1984) points out that, traditionally, control of a corporation was exercised by its owners
either in a straight line or through control of management. Nevertheless, when ownership and
management are separated, as when ownership becomes fragmented, control of the corporation
presents an important challenge. The issue of the separation of management from ownership, which
results in the transfer of control of corporations from owners to professional managers (Scott, 1997),
received greater emphasis following the rerle and Means article: The Modern Corporation and Private
Property (rerle and Means, 1932).
They observe that:
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rerle and Means suggest that the notion of ownership of property when employed to corporations
particularly large ones, is not simple. It is in this context that Minztberg (1984) poses the question: who
should organize the corporation, and for the pursuit of what goals? Minztberg contends that as
ownership of corporations became discrete, owner-control weakened and corporations came under the
contained control of their managers. Stiles and Taylor (2002) point out that although corporate
governance as a subject has fascinated extensive interest internationally, the nature of the debate about
it is still basically shaped by the rerle and Means analysis.
  


    
The issues that have encouraged interests in the phenomenon of corporate governance, spot to
particular causes of corporate governance crises. These comprise feeble legal and regulatory systems,
contradictory accounting and auditing standards, and poor banking practices. Thin and poorly regulated
capital markets, unproductive oversight by corporate boards of directors, and little regard for the rights
of minority shareholders are also problems with respect to corporate governance (World rank, 2000).
The problem of pathetic legal and regulatory systems is usually viewed as a problem of developing
countries. Developed economies tend to have developed and complicated regulatory systems, while less
industrialized ones tend to display less efficient systems of law and regulations (Lin, 2000). The thinness
and lack of effective stock exchange regulation may also be seen as chiefly part of the problem in
developing countries. This is connected with the low level of market development in such economies
(Lin, 2000; World rank, 2000). When legal and regulatory systems are weak, the enforcement of
contracts becomes difficult. For instance due to weak legal and regulatory systems, particularly the
enforcement of laws in Russia and the Czech Republic, controlling shareholders were
able to draw off profits leading to a loss of investments by minority shareholders (World rank, 2000).
The application of varying accounting and auditing
standards is another challenge to corporate governance ͞A well-governed company takes a longer-
(Clarke and Clegg, 1998). This problem emanates from term view that integrates environmental and
the use of a variety of financial accounting standards by social responsibilities in analyzing risks
corporations whose operations span to diverse discovering opportunities and allocating
countries in the preparation and presentation of capital in the best interests of shareowners.
financial statements (rradley et al., 1999). For instance, There can be no better way to restore public
US Corporations employ an American system of GAAPs confidence in both businesses and markets
developed by FASr, whereas UK-based corporations and build a prosperous future.͟
apply a dissimilar set of accounting standards (SSAPs) Õ

 4
ͶExecutive Director UN Global
developed by the Accounting Standards roard (ASr) Compact
and the Financial Reporting Council (FRC). This use of unlike accounting standards makes the evaluation
of performance across companies operating internationally complicated (rradley et al., 1999). This
challenge has led to the need to correspond standards through the use of accounting standards
promoted by the International Accounting Standards roard (IASr). This initiative is reflected in the
current attempts to harmonize accounting standards in Eastern, Central and Southern African regions
through the Eastern, Central and Southern Africa Federation of Accountants -ECSAFA (Gathinji, 2002).
The poor banking practices reported by the World rank are particularly related to the Asian crisis where
banks provided credit to companies under the influence of the political elite. Either one family, or a
corporation under a family͛s control, generally own Asian firms. Such families have close connections
with the government, and politicians, and dominate the national economy to a large extent (Hanazaki
and Liu, 2003). Using these connections, corporations have been able to borrow funds from banks
without the proper disclosure of the information required to enable full evaluation of company
performance and establish creditworthiness (World rank, 2000).
The cases of Maxwell, rCCI, Nomura and a number of other large corporations show how the lack of
effective oversight by directors can lead to corporate governance crises. This lack of effective oversight
by boards of directors has resulted in boards' failures to prevent a large number of fraud cases and the
subsequent collapse of corporations (Tricker, 2000; Stiles and Taylor, 2002). Mace (1971) argues that
boards of directors are 'Christmas ornaments' and do not effectively control senior managers. Demb and
Neubauer (1992), posit that this is paradoxical since chief executive officers exercise the power of
corporations which should be the preserve of directors.
*

  

.
 
Corporate governance can be addressed from two broad perspectives: the liberalist and the
communitarian perspectives (rradley et al., 1999; Clarke and Clegg, 1998). The liberalist perspective
views corporations as only accountable to shareholders. In this perspective, a corporation's legitimate
goal is to serve the interests of those who own it i.e. the shareholders. The legitimate claims of other
stakeholders are satisfied by meeting the contractual terms between them and the corporation. Within
the communitarian perspective, corporations are required to be accountable to other stakeholders than
the shareholders alone. In this respect, shareholders become one stakeholder group among a number of
stakeholder groups. The results of these differing views are different goals for corporations, for which
managers are held accountable (rradley et al., 1999). The case of SGL, a German manufacturer of
graphite and carbon which wanted to attract capital from American investors, is provided to illustrate
the implications of these perspectives.
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The case of SGL highlights the debate that has been going on for over a hundred years regarding the
primacy of individuals versus the primacy of community (rradley et al., 1999). This debate tends to be
settled in each society in favour of one or the other: in Anglo-Saxon societies, the individual is assumed
to have primacy and therefore his/her freedom to pursue their own goals, aimed at the maximization of
their own utility, is argued for. This freedom is recognised in economic spheres and is actualised through
the notion of private property. Respect for private ownership is central in the pursuit of economic
activities, and in enjoying the benefits of such activities. A corporation is viewed in the same way as
private property, and considered to belong to those who have put in their money as capital for the
purpose of pursuing their economic interests
(Scott, 1997). The goal is thus the maximisation ͞Good corporate governance is the glue that holds
of the wealth of its shareholders. In the above together responsible business practices, which
case, shareholders in the US required SGL to ensures positive workplace management,
commit itself to this goal. marketplace responsibility, environmental
The SGL case implicitly points to an alternative stewardship, community engagement, and sustained
perspective regarding the notion of freedom financial performance. This is even more true now as
one in which the primacy of individuals is we work worldwide to restore confidence and
recognised but within the bounds of the larger promote economic growth.͟
society. In this context, the argument is Thierry ruchsͶ Head Private Sector Development
advanced for individuals to pursue freedoms Division of Switzerland͛s State Secretariat for
subject to constraints imposed by society, and Economic Affairs (SECO)
the economic activities pursued should serve some social goal (Fisher and Lovell, 2003). In the context of
Germany, where SGL is based, corporations are expected to have goals that reflect the interests of a
number of stakeholders in addition to shareholders (Weimer, 1995). This perspective is usually viewed
as being broad (Clarke and Clegg, 1998).
The SGL case shows that the globalisation of capital in a world that is dominated by American
corporations is forcing other countries (or corporations in other counties) to re-evaluate their
governance systems in an attempt to meet the demands of multinational corporations. Monks and
Minnow (2002) point out that when Mercedes renz wanted to raise capital on the New York Stock
exchange, it had to adapt to the US accounting practices to facilitate investors͛ evaluation of the
company. The American system of corporate governance requires corporations to apply accounting
practices that align financial reporting with the interests of parties outside the corporation with respect
to the provision of information these parties require. The accounts are required to present a ͞true and
fair͟ view of the business in the American system, as opposed to the ͞true and correct͟ requirement of
the company law in Germany (Kendal and Sheridan, 1991). These authors point out that such a system
helps parties outside the firm, particularly shareholders, to evaluate the corporation͛s performance to
assess the return on investment. In the German communitarian perspective, corporations are required
to comply with detailed civil laws governing accounting.
The two perspectives are of great importance in the
discussions on corporate governance. Corporate
governance practices are expressions of these Ä

  
perspectives, and are embedded in the problem of social  

conflict (Roe, 2003). Corporate governance evolves to
address incentive problems brought about by the Corporate governance refers to the
separation of ownership from management (Tricker, way that roards oversee the
1994). The two perspectives shape the manner in which running of a company by its
corporate governance develops. The Anglo-Saxon managers, and how roard
perspective suggests a conflict perspective, and thus members are held accountable to
corporate governance evolves to protect the interests of
shareowners and the company.
shareholders (Albert, 1993 cited by Macquand, 1993). In
other countries, for example Japan and Germany, This has implications for company
corporate governance is viewed as enhancing behavior not only to shareowners
performance for the long-term survival of the but also to employees, customers,
corporations and for the benefit of multiple stakeholders those financing the company, and
(Sebora and Rubach, 1998; Weimer, 1995; Maassen, other stakeholders, including the
1999; Letza et al., 2002). The distinct perspectives communities in which the business
indicate that understanding the prevailing perspective in
operates.
a particular context is of paramount importance in
understanding corporate governance in that context. Research shows that responsible


.
 
   +

management of environmental,
The central planning system for economic coordination in
social and governance issues
Tanzania, and the ownership of corporations by the state,
implies that the important experiences of corporate creates a business ethos and
governance will be related to stateowned corporations. environment that builds both a
retween 1967 and 1992, state-owned corporations were company͛s integrity within society
the most common type of large corporations found in and the trust of its shareowners.
Tanzania. In these corporations, corruption,
(embezzlement and nepotism) managerial incompetence,
political interference and government subsidisation of
failing corporations were the predominant characteristics
of corporate governance. Corporations were shielded from the discipline of the market (ragachwa,
1992; Kihiyo, 2002). Control and accountability became the prime casualty within these corporations.
ragachwa et al. (1992) point out that the lack of accountability and effective control of these
corporations left the managers with unfettered powers. They attribute these problems to the
ambiguous property rights in the state-owned corporations.
The problems reported by ragachwa et al. apply to a large extent to other countries in sub-Saharan
Africa. Etukudo (1999) reports the paucity of corporate governance in sub-Saharan Africa arising from
the ambiguous relationship between the state, as the owner of the corporations, the boards of directors
and senior management. The paucity of corporate governance in state-owned corporations in Tanzania
has resulted in dismal performance and the failure of these corporations (Wangwe, 1992). One result of
the poor performance of these corporations has been their inability to provide the necessary ͞push͟ for
the attainment of social and economic development as envisaged by the post-independence
government (URT, 1999).
The system of central planning, including the state ownership of corporations, is being reformed
through a series of market-promoting schemes. This process formally started in 1986 following an
agreement between the Government of Tanzania and multinational financial institutions ʹ the IMF and
the World rank - in 1986 (Mukangara, 1993; World rank, 2002). The reforms included adoption of
competition friendly policies and the transfer of ownership of state assets/corporations to private
shareholders. There had been earlier minor reforms towards a market orientation, e.g. the National
Economic Survival Programme (NESP) of 1981-1982. Nevertheless, these were largely unsuccessful, and
this justified the need for the more comprehensive reforms that began in 1986 (ragachwa et al., 1992).
Following reforms, a number of corporations have been privatised. Some of the privatised corporations
have shown important improvements in their performance (URT, 2003). Indeed, privatisation has been
viewed as a solution to the problem of governance (Wangwe, 1992).
Developments in the African region and worldwide have also created the need to develop an
understanding of corporate governance practices in Tanzania. As a member of the African Union (AU),
Tanzania is required to join the comity of other African countries in improving corporate governance
practices. The Africa Union has developed a development vision in which member countries are
individually required to implement initiatives to improve corporate governance practices within them.
This vision, called New Partnership and Development (NEPAD), recognises corporate governance as one
of the key issues that need to be addressed to achieve social and economic development on the African
continent. The vision underscores that issues of poverty alleviation are best addressed through wealth
creation, in which corporate governance plays a key role since it improves efficiency in the allocation of
resources. Thus, NEPAD draws a direct link between corporate governance and wealth creation
(Gathinji, 2002).
Away from the African region, Tanzania is also a member of the rritish Commonwealth. The member
countries of the Commonwealth have agreed to undertake measures to perk up corporate governance
practices (CACG, 1999). CACG points out that corporate governance is significant in improving the
competitiveness of member states in attracting capital and in enhancing the performance of
corporations.
 

'  
Tanzania is a developing country situated in the Eastern African region, positioned around 5° South of
the Equator and 45° East, and covers 945,087 sq km. It is bordered to the North and North East by
Uganda and Kenya and to the North West and West by Rwanda, rurundi and the Democratic Republic of
Congo. To the South and Southwest lie Mozambique and Zambia respectively, and the Indian Ocean lies
to the East.
Tanzania is made up of Tanganyika and Zanzibar. Tanganyika regained its independence in 1961 from
the rritish, and became a republic in 1962. Zanzibar regained its independence from the Arab Sultanate
in 1964. The two joined to form the current union ʹ called the United Republic of Tanzania (URT) - in
April 1964. Tanzania was a single party state from 1965 to 1991. In 1992 a multiparty political system
was re-introduced; and twelve political parties had obtained their registration by 1993 (Muya, 1998).
Chama Cha Mapinduzi (CCM) has since been the dominant political party. Elections for both the
presidency and parliament are held every five years. Tanzania is viewed as having been one of the most
politically stable countries in Africa since independence. The transition towards a multiparty political
system has also been peaceful. This stable environment is viewed as providing a base for rapid economic
growth (URT, 1999)
Dar es Salaam constitutes the operating de facto capital of Tanzania. The designated de júre capital is
Dodoma. The decision to move the capital to Dodoma was made in 1973. Thirty years on, the
government continues to insist on moving to Dodoma. Nevertheless, only four out of the current
thirteen ministries have moved to, and currently operate from, Dodoma. The rhetoric of moving the
capital to Dodoma continues, although with much less vigour than in earlier times. For example, in July
2003, the President reminded ministers to prepare themselves for the move to Dodoma, insisting that
the decision to move to Dodoma was irreversible. This illustrates one of the gaps between ideology and
practice in the country.
Tanzania, in terms of economic potential, is endowed with a rich natural resource base and easy access
for international trade. 46% of its land is suitable for agriculture (with only 6.7% of it being cultivated), it
also has a large hydropower potential, a wide range of mineral deposits including gold, diamonds, tin,
iron, uranium, phosphate, gemstones, and nickel, and also natural gas. Other resources include exotic
varieties of wildlife and a number of tourist attractions (World rank, 2002). Despite this potential and
rich resource endowment, Tanzania remains one of the least developed countries in the world; poverty
remains pervasive and deep. As illustrations, about half of the Tanzanian citizens are poor, 32 percent
illiterate and the infant mortality rate stands at 99 per 1000 live births (World rank, 2002). This suggests
that the resources are not being sufficiently utilised to bring about social and economic development.
The appalling level of poverty forms the basis for the current strategy for poverty eradication (Chachage,
2003). The economy experienced a severe crisis in the 1980s. Nevertheless, recently, changes have been
taking place with positive growth being registered. In comparative terms, the economy of Tanzania has
been showing positive growth since mid-1990s. Table 6.2 provides the output growth rates for Tanzania,
Africa, developing and developed countries over recent years.
$804

.
'  22FA4556
 
>
  22F 222 4555 455 4554 4556
Tanzania 4.0% 4.7% 4.9% 5.9% 6.2% 5.6%
Africa 3.3% 2.3% 3.0% 3.6% 3.4% 4.1%
Developing Countries 3.0% 3.8% 5.8% 3.9% 4.6% 6.1%
Developed Countries 2.0% 3.4% 5.8% 0.8% 1.8% 2.1%
The World 2.0% 3.5% 4.8% 2.3% 3.0% 3.9%
Table 6.2 shows that the economy has been growing over the last six years; with annual growth rates of
more than 4%. This growth is greater than that for the whole of Africa, and also that of both developing
and developed countries as well as the world's overall performance. The strong economic growth rates
point to increasing efficiency in the utilisation of available in the economy.
Tanzania remains largely an agrarian economy. The rural population, about 76% of the total population,
relies on agriculture for its livelihood, and forms an significant source of foodstuffs for the urban
population (World rank, 2002). Agriculture has been contributing about 48% to the GDP over the last
ten years. This sector is linked to a large number of other sectors of the economy particularly industry
and commerce. It is for this reason that the belief is held that the development of agriculture will result
in rapid economic development in Tanzania (TANU, 1967; Nyerere, 1968, World rank, 2002).
Other significant sectors of the economy include trade, hotels and restaurants; financial business
services; and manufacturing. Trade, hotels and restaurants (combined) form the second most significant
sector of the economy, and has been contributing about 16% of GDP over the last ten years. This sector
is gradually growing reflecting recent developments linked to the adoption of market reforms that
began in 1986. The reforms have led to increased trade and growth in the tourism industry. For
example, in 1998, tourism contributed 7.6% to the GDP up from a paltry 1.5% in the early 1990s. This
sector has recently been growing at an annual rate of 22% (World rank, 2002).
The financial services sector is the third largest contributor to the economy of Tanzania. This sector has
had a stable contribution to the GDP of about 10% over the last ten years. The manufacturing sector
ranks fourth in terms of contribution to GDP, with a consistent contribution of about 8% between 1992
and 2002. The public sector, transport and communication, construction, mining and quarrying,
electricity and water are other significant sectors of the economy. With respect to the phenomenon of
corporate governance, the analysis of relevant context is considered in this research to begin with the
colonisation of the country since this marked the beginning of corporate development leading to current
practices.
From a historical perspective, the abolition of the slave trade in the later part of the nineteenth century
(around the 1870s) saw an increased interest by the Western powers seeking to establish spheres of
influence on the African continent and in other parts of the world. In the context of Tanzania, the first
colonial experience began with the German colonisation of Tanganyika following the outcome of the
rerlin Conference of 1884-1885. German rule lasted from 1884 to 1919. With respect to corporate
governance, laws constitute the main way in which colonial experience influences prevailing corporate
governance practices in colonised countries (Djankov et al., 2003).
Nevertheless, the influence of German law on corporate governance is nowadays nonexistent in
Tanzania. This is for the reason that World War Two led to Tanzania becoming a protectorate of the
rritish following the endorsement of the League of Nations (now called the United Nations). This was
the point at which rritish colonial influence penetrated Tanzania, the legacies of which are still present.
The most important legacy of this linked colonial past, with respect to corporate governance, is the
rritish legal system which has provided the framework for corporate governance in Tanzania to the
present time.
In addition to the legal system, systems of economic coordination are significant determinants of
corporate governance practices (Gilpin, 2001). They reflect assumptions about social life in different
societies, and how economic activities are coordinated. Corporate governance practices are embedded
in systems of economic coordination. The cultural, legal and institutional aspects of different societies
influence corporate governance (Tricker, 1994; Sebora and Rubach, 1998). An understanding of the
systems of economic coordination is helpful for placing corporate governance practices in their
appropriate context.


 


.
 
   

 
  
   
The two systems of economic coordination within which business has been operating imply that
corporate governance can be discussed under the two forms of economic coordination. The centrally-
controlled system of coordination had implications for corporate governance practices with respect to
state-owned corporations. This was the most significant form of corporation during the Ujamaa and
Kujitegemea era. Figure 6.3 indicates the system of governance that evolved with respect to state-
owned corporations under the centrally-controlled system. The figure shows three different levels of
governance: the people, the ruling party, and the government and parliament (Mwapachu, 1983). The
way in which state-owned corporations were to be governed was stated in the Public Corporations Act
and by individual Acts that established specific corporations. In this regard, the Public Corporations Act
of 1969, amended in 1976, applied until 1992, when the current Public Corporations Act was enacted.
 h

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TANU aimed at placing the ownership of enterprises in the hands of the Tanzanian people through their
government and that they would exercise ultimate control of corporations both directly and indirectly.
Direct governance involved the use of social pressure brought to bear on the managers of the
corporations. Social pressure is recognised as one of the mechanisms by which corporations can be
controlled (Demb and Neubaeuer, 1992). For example, complaints about the conduct of managers
reported in the media constituted one of the deterrents to the abuse of the power entrusted to
managers (Mwapachu, 1983). People could also send reports to the Permanent Commission of Inquiry
which was established to address the problem of abuse of power and corruption practiced by civil
servants including the managers of state-owned corporations.
Indirect control by the people was exercised through the ruling party, TANU and later CCM. Control
through the party was more prevalent during the early days following the Arusha Declaration and was
mainly exercised through party directives to the government (Mwapachu, 1983). The notion of party
supremacy is applied to express the extent of control that the ruling party exercised (Kiondo, 1993).
Party control was also exercised through the appointment of party representatives9 who were placed in
corporate offices. These officers reported directly to the national party organs on the performance of
the managers of the corporations.
They could send confidential reports to the national party organs such as the National Executive
Committee (NEC). This way of reporting gave representatives important influence on the management
of state-owned corporations; managers feared the disciplinary action that could be taken against them if
they were reported to the NEC.
 
     

Parliamentary control was (and still is) exercised at two stages. At the stage of debating and approving
the bill, and during the life of a corporation. At the establishment stage, the government, through a
sector ministry under which the corporation would be placed, is required to satisfy the parliament of the

9
Party representatives were individuals appointed by the party (i.e., CCM) to promote the party͛s policies at places
of work.
relevance of the corporation to be established. This was to ensure that the corporation being proposed
fitted the national interests in terms of development plans, and that public funds were directed into
significant areas. There were problems, nevertheless, in relation to those state-owned corporations
which were established by presidential order10. In this event, the parliament has no way of vetting the
usefulness of a corporation.
Parliamentary deliberations about the performance of corporations were (and still are) useful ways of
exercising control over state-owned corporations. In 1978, the Parliament established a Parastatal
Organisations͛ Accounts Committee which served as an significant control mechanism. This committee
verified whether funds utilised were legally appropriated and whether funds have been expended on
approved services and projects. The Committee also looked into budget overruns, and the reasons for
them, and checked for wasteful utilisation of public funds. In discharging its responsibilities, the
committee employed the services of the controller and auditor general (CAG) and those of the Tanzania
Audit Corporation (Mwapachu, 1983).
(

).
  

  
 

Presidential control has been both formal and informal. Formal control applied to specific corporations
that, by the Act establishing them, had to report directly to the President. These include the Capital
Development Authority (CDA) and the Rufiji rasin Authority (RUrADA). Presidential control was exerted
over all other corporations through the appointment of the chief executives/chairmen of the holding
corporations. According to the 1992 Act, the President appoints the chairmen of those corporations in
which the government is the only shareholder.
According to the 1969 and 1992 public corporation acts, the appointments have to be based on
recommendations by the sector ministries. Further presidential control, over state corporations, was
exercised informally through consultation and planned visits by the President to these corporations. The
President also exercised control through his powers to require corporations solely owned by the
government to keep records as the President directed. The borrowing powers of such corporations are
also vested in the president.
Mwapachu (1983) reports that during the customary annual consultation sessions between the
president and the heads of public corporations, particularly holding corporations, the managers of the
corporations were required to present their latest briefs on their performance and problems. These
occasions also served as forums for managers to present their problems and receive support in areas
such as foreign exchange. The occasional visits provided a means for interaction between the president
and directors and senior management of public corporations. During these visits the President is
reported to have made orders on steps that needed to be taken. The President also had a fully-fledged
advisory economic unit which is regarded as having been useful in gathering information about the
performance of corporations and advised the President accordingly. This provided the President with
further opportunities and means for exercising control over corporations.
 
 

Ministerial11 control concerns sectoral control over state-owned corporations. The 1969 Presidential
Circular No 2 stipulates that each state corporation should be responsible to one sectoral ministry
(Mwapachu, 1983). Sector ministers exercise control over corporations through: ministerial directives,
ministerial appointment of directors of parastatals, access to information on demand, control of
borrowings, budget approval, control over investments and audit scrutiny. Ministers are empowered by
law to provide directives of both general and specific character to state corporations. The ministers are

10
In Tanzania, corporations could be established either by Act of Parliament or by presidential order.
11
In Tanzania, the President appoints all the ministers with the prime minister only requiring parliamentary
approval. Ministerial control can therefore be considered as indirect presidential control.
responsible for ensuring that the corporations operate in the national interests. Mwapachu (1983)
contends that the lack of a clear definition of the national interests left the issue open to interpretation
by the responsible minister. This control could be applied in ways that could frustrate management and
lead to the poor performance of the corporations. The 1992 Act still requires the minister of the parent
ministry to give corporations directives. Section 6 of the Act states:
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The 1992 Act also gives the minister of the parent ministry the power to appoint directors for
corporations in which the government is the sole shareholder. With this Act, every proposed
appointment has to be forwarded to the treasury registrar. The Act specifies that where the government
is not the sole shareholder, instruments under which such corporations are established govern the
appointment of directors. When the directors are appointees of the minister, the boards provide the link
between the minister and the management of the corporation.
The responsibilities of boards of directors of holding corporations include the development of
mechanisms for sending information to the ministers of the parent ministries and reporting about the
property of the corporation as well as its operations. Directors were also required to submit, to the
minister, accounts (including annual reports) and any other reports the minister demanded. A copy of
the audited annual accounts had also to be made available to the sector ministry.
As part of ministerial control over investments, most of the parastatals could not (and still cannot) take
out loans or overdrafts without prior approval of the sector minister. In some cases, both the sector
minister and the Minister for Finance must approve any borrowings. For example, Tanzania Railways
Corporation (TRC) cannot undertake borrowing without the prior approval of the sector ministry as well
as of the Minister for Finance. The 1981 laws covering miscellaneous amendments introduced this
double control for all state-owned enterprises.
In relation to budget approval, budgets prepared and approved by boards of directors must be in the
form and detail specified by the parent ministry; final approval of the budget rests with the minister.
Investments of funds by public enterprises are also subject to approval by the parent ministries.
Nevertheless, there were variations with respect to investments. For example, in the case of Tanzania
Posts and Telecommunications Corporation 12 there was no such requirement, whereas such a
requirement exists for the roard of Internal Trade, National Lotteries, and the National Milling
Corporation (Mwapachu, 1983).
With respect to holding-subsidiary relationships, holding corporations act on behalf of the parent
ministry. The performance of the holding corporations reflect the performance of their subsidiaries.
Prior to 1992, holding corporations, operating under parent ministries, were treated as custodians of
government equity in the operating companies (subsidiaries and associates13). They were charged with
the responsibility of overseeing the individual companies. These holding corporations included the
National Development Corporation (NDC), the National Textile Corporation (NATCO), the National
Agricultural and Food Corporation (NAFCO), the State Mining Corporation (STAMICO) and the Livestock
Development Authority (LDA) (Mwapachu, 1983). In relation to their overseeing function, the holding
companies were required to carry out a number of activities: planning, promoting, organizing and
integrating subsidiaries into a specific sector of the economy, and acting as entrepreneurs on behalf of

12
This company has been split into three separate companies for Postal Services, Telecommunications and the
Postal rank.
13
A subsidiary company is one a holding corporation has a controlling stake (above 50% equity) while an associate
is one in which it has shares but a controlling stake.
government. Thus, holding corporations were required to identify new areas of economic investment
and to participate in carrying out such investments. They were also required to coordinate the activities
of subsidiary companies in terms of defining the economic and financial objectives, guide and direct
their performance for optimal capacity utilization, and review and control performance using budgetary
controls. Holding corporations were also required to appoint directors and the top management of
subsidiaries, and provide research, marketing and development services, recruitment and training
services at the management levels. Auditing, financial management services and the determination of
salary structures, in collaboration with relevant Government authorities particularly SCOPO, were other
duties of holding corporations with respect to subsidiaries.
 
 

Central control refers to the exercise of control by the treasury registrar. This is part of the formal
control exercised by the government. Formal mechanisms are ones that have been stipulated in the law
that established state-owned corporations, i.e. the 1969 Act and relevant regulations. The post of
treasury registrar was first established by the colonial government for the purpose of controlling and
allocating the resources of that government. The post independence government adopted the same
model14. This office, in the Ministry of Finance, is there to acquire, hold and manage investments of the
government.
Under the control of the treasury registrar various mechanisms were instituted. These include the
establishment of committees designed to enable the treasury registrar to exercise control. For example,
the treasury registrar established a special committee on parastatal management agreements for the
purpose of evaluating proposals for management agreements with state-owned corporations. It also
established a finance and credit plan council, under the direction of the Ministry of Finance. This was to
ensure that financial resources, accruing to the government and its institutions, were put to priority use.
It also ensured the involvement of financial institutions in financial management and credit allocation.
Central controls also included a control function for banks and financial institutions by the rank of
Tanzania (rOT) through the Government Loans, Guarantee and Grants Acts of 1975.
The Tanzania Audit Corporation (TAC), the National Price Commission (NPC) and the Standing
Committee on Parastatal Organisations (SCOPO) were also involved in the control of state-owned
corporations. The control role of the TAC related to powers and obligations to provide audit and
auxiliary services including advisory and accounting services. NPC exerted control on enterprises
through its powers to fix and control prices of products and goods both produced within the country
and imported.
The argument behind the establishment of the NPC was to ensure that corporations realised profits by
increasing efficiency rather than through exploitative pricing. In that way, NPC would protect consumers
from unreasonable pricing as well as limit the competition that existed between private and public
enterprises. While this objective was plausible it was not achieved. Wangwe (1992) points out that price
controls did not offer incentives for efficiency for the reason that inefficient managers could price their
goods/services at the stipulated prices where they could have been lower if efficiency was effected.
In the early days of the Arusha Declaration, the remunerations of employees of state corporations were
set by SCOPO. SCOPO was established immediately after the nationalisation policy of the Arusha
Declaration to: formulate training programmes for employees of state-owned corporations, review
salary and benefits of parastatals to bring them into line with those of other public servants with
comparable skills, review and approve the conditions of employees seconded from public service to
state-owned corporations, approve transfers between parastatals and the Ministry of Manpower
Development and to review localisation arrangements with state corporations to bring them in line with
the government policy requiring all posts be filled by competent citizens. According to the 1992 Act, all

14
Treasury Registrar Act of 1959, 1980.
the activities that SCOPO once performed have become the domain of boards of directors of these
corporations. Figure 6.2 depicts the governance system of state-owned corporations.

   

.
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The corporate governance of state-owned corporations reflects the role of the state in coordinating economic
activities. The former corporate governance system of stateowned corporations was a complex system which
faced a number of problems with respect to control and accountability. At the level of the people and the party, it
15
can be argued that, when ownership is so fragmented, free rider problems occur which lead to an absence of
monitoring (Hart, 1995). It cannot, be expected that the people would have the motivation and adequate
information about the performance of corporations to exert sufficient pressure on management.
At the presidential/ministerial level, there are also problems of information and incentives. For example, with
regard to holding corporations, the President appointed the CEO/chairmen while the sector minister appointed
other directors. The directors could not exercise control over the decisions of the CEO/chairman. The minister
under whom the corporation was placed could not discipline the CEO if they wanted to, except by making
recommendations to the appointing authority. Kihiyo (2002) raises the problem of information not reaching the
President in time for action. Nevertheless, it can be argued that information might not reach him at all and, even if
it did, it could easily be distorted in line with the interests of the people in the chain of command in the matter
being reported. The system was therefore informationally deficient, permitting problems to go unchecked.
In addition to the problems relating to the structure of the corporate governance system, state-owned
corporations operated without clear objectives. Social and economic objectives were imposed, instructions to
management from government ministries conflicted those from other government agents, political interference
was rampant and the role of the state as shareholder and regulator of business was ambiguous (Wangwe, 1992).
The result was a lack of specific criteria for assessing performance. The system was also bureaucratic in that
decisions had to follow a number of steps before action could be taken. This slow pace of decision-making
translated into a lack of the flexibility needed to take advantage of opportunities.
The ineffectiveness of the corporate governance of state-owned corporations contributed to their poor
performance. Gregory and Simms (in Monks and Minow, 2002) suggest that the effectiveness of corporate
16
governance will be reflected in a firm͛s performance . A study conducted by the Ministry of Finance in 1974 of 24
parastatals showed that, by the end of 1973, they had accumulated TAS 178 million (equivalent to US$ 35.6 million
at that time) in losses which accounted for 91% of the total capital allocated to these parastatals. ry the late
1980s, the public corporations were regarded as such a burden on the state that they had to be divested. These
governance problems resulted from a system that made managers accountable to those who appointed them
rather than to the people; these ͞management problems͟ point to the lack of control and accountability
(Chachage, 2003).
    %
 
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At the level of the corporation, the ongoing reforms have implications for the form of corporate governance that
will evolve. High levels of poverty characterise the social context in which economic reforms are taking place in
Tanzania (Mtatifikolo, 1992; World rank, 2002). This limits the extent to which the majority of local people can
effectively participate in the process of reforms, with particular reference to the privatisation of the state-owned
17
corporations. For the reason that of the shortage of local capital, privatisation through strategic investors has
become an significant method for privatising state-owned corporations.
Privatisation through strategic investors has implications for corporate governance: it provides an opportunity for
a small number of individuals and corporations to acquire significant holdings in the privatised corporations and
hence result in a concentration of ownership in the corporations. This issue was of concern during the early years
of privatisation. Ngemera (1993) cautioned that if privatization was not carefully handled, it could end up by

15
Free rider problems refer to owners of a corporation who individually hold only a small number of shares and
who thus individually lack an incentive to monitor management and take corrective action.
16
There are no clear measures to establish the link between performance and corporate governance.
Nevertheless, it is believed that corporate governance has an important influence on the performance of
corporations.
17
A strategic investor is one who acquires an important number of shares in a corporation in order to become
either a controlling or a important shareholder entitling him to important control rights.
creating an economy which was either foreign dominated, or locally dominated by a small group of people.
Notwithstanding these warnings, the majority of the privatised corporations have single controlling shareholders18.
Although poverty is generally considered to have reduced the ability of indigenous people to acquire the privatised
corporations, leading to a greater reliance on strategic investors, other reasons for the reliance on strategic
investors have been suggested. Chachage (2003) observes that:
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The above comment implies that a number of individuals have exploited the reform process for private gain. The
process of privatisation has been criticised by members of the public, including members of parliament, for being
indifferent to the interests of local people (Simba, 2003)19. Table 6.2, provides a list of some of the companies that
have been privatised, and the extent of ownership concentration in such companies. The majority of the
corporations in Table 6.4 have been referred to as major corporate taxpayers by the Tanzania Revenue Authority
(TRA)20 which points to their importance in the economy particularly with respect to their contribution to the
government revenues (URT, 2003).
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TCC* 75 2.5 19.5 Tanzania Cables 51 49 -
TrL* 52.8 4 43.2 Kilombero Sugar Estate 75 25 -
Arr Tanalec Ltd 70 30 - Tanzania Portland 55 45 -
rlankets and Textile 100 0 - Mbeya Cement 100 0 -
MKONO (formerly 100 0 - TANESCO Wood Plant 100 0 -
called HANDICO)
Morgoro Canvas 100 0 - NArICO 100 0 -
DAHCO 51 0 49 Tanzania Pharmaceutical 60 40 -
Mtibwa Sugar Estate 95 5 - Sungra Textiles 100 0 -
Maponde Tea 100 0 - NrC 55 30 15
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* These include individuals, other corporations and institutional investors.

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The legal framework for privately-owned corporations in Tanzania is linked to the colonial past. Djankov et al.
(2003) point out that when European powers conquered and colonised other nations, they brought with them a
large number of their political, legal and regulatory institutions, and most significantly their laws. England
transplanted its laws to the United States, Canada, Australia, and other members of the Commonwealth including
Tanzania. In this respect, the company ordinance of 1932, whose origin is in mid-1800s Great rritain, is relevant in
Tanzania. For this reason, the corporate governance framework in Tanzania has some semblance to that of the UK.
Essential elements of the legal framework include the incorporation and governance of corporations. The model
that applies in Tanzania was developed in England in the 17th century and was transplanted to Tanzania through
colonial channels.

18
The PSRC annual reports for 2002/2003 indicate that the majority of privatized corporations have controlling
shareholders.
19
The rise of the indigenization debate in Tanzania is reflective of the indifference by the government to local
interests. The whole privatization process in Tanzania has been criticized for a number of reasons.
20
TRA has established a special unit that deals exclusively with these major corporate taxpayers.
In England, an 1844 Act laid down the mode of a company in which people who subscribed their names to a
memorandum of association became its shareholders (Tricker, 2000). The concept of limited liability for members
was introduced in 1854. In general, the underlying principle of incorporation has not changed. This principle is
reflected in the Company Ordinance (Cap. 212) as well as in the Company Act of 2002 which repeals the Company
Ordinance when it comes into operation. This law reflects the English individualism (at the onset of enlightenment)
of the 13th century characterised by the market, urbanizing society and eventually industrialization (Tricker, 2000).
Ownership in a company provided shareholders with property rights which permitted them to participate or be
represented in the company decision-making organs such the board of directors and annual general meetings.
Company law, Cap. 212 section 26, states:
(1) The subscribers to the memorandum of a company shall be deemed to become members of the
company and on its registration shall be entered in its register of members
(2) Every other person who agrees to become a member of a company and whose name is entered
in its register of members, shall be a member of the company.
The Company Act, 200221 has not departed from Cap. 212 importantly. Section 24 (1) and (2) of the Act defines
members of the company as those who have subscribed to the memorandum of the company; sec. 133 (1) (a-f)
describes the meetings of members where disclosure is executed by directors through financial reporting and the
directors͛ report as means of accountability. Founders of a company prepare MEMARTS which detail the way in
which the company is governed internally, and the way in which it relates to the outside world. The MEMARTS
have to be drawn up within the framework of company law and to suit the shareholders of a company. Other
relationships between the company and various other constituencies e.g. employees and managers are regulated
by employment contracts and other relevant contracts. This approach to corporate governance has been referred
to as the contractarian approach (rradley et al., 1999).
Figure 6.3 depicts the model of corporate governance that applies in Tanzania. It involves the relationship between
shareholders as providers of capital and directors and management as agents of shareholders. Table A of Cap. 212
requires companies to be managed by directors appointed by members. The ordinance specifies a number of
issues with regard to the power of directors and members (shareholders) in the governance of the companies. In
terms of Figure 6.3, the model that applies in Tanzania, as provided in Figure 6.4, falls both within the classical and
challenge perspectives of economic coordination. roth these perspectives respect the freedom of the individual,
including their property.
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The Company Act 2002 requires directors to act in good faith and in the best interests of the company.
Cap. 212 does not specify this role. Section 182 of the Act states:
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21
The new law has been passed by Parliament and accented to by the President of Tanzania. Nevertheless, its
operationalization awaits regulations from the Minister for Trade and Industry.
The new Company Act also expands the scope of the accountability of directors to include their
accountability to employees and assigns equal importance to the interests of both parties. Section 183
of the Act states:
(1) ͞The matters to which the directors of the company are to have regard in the performance of
their functions include, in addition to the interests of members, the interests of employees͟.
(2) ͞The duty imposed by this section on the directors is owed by them to the company (and the
company alone) and is enforceable in the same way as any other fiduciary duty owed to the
company by its directors͟
Consistent with vision 2025, the establishment of the rusiness Registration and Licensing Agency
(rRELA) under the Government Executive Agency Act No. 30 of 1997 is an attempt to promote the
private sector and entrepreneurship in the country in line with the new philosophy of a market-based
system. rRELA is a semi-autonomous agency, under the Ministry of Industries and Trade, charged with
the responsibility of facilitating and regulating business activities in the country. The responsibilities of
the agency include: registration of both local and foreign companies; registration of business names;
registration of trade and service marks; granting of patents; overseeing copyrights and neighbouring
rights administration in Tanzania; issuing business and industrial licenses.
The four forms of companies that are recognised under Tanzanian company law are private companies,
public companies, foreign companies and state-owned corporations. Private companies are defined as
those that restrict the right to transfer shares, limit the number of its members to fifty and prohibit
inviting the public to subscribe for any shares or debentures in the company (Cap. 212 sec 27 [1(a-c)].
The shares of private companies are not tradable on the stock exchange. Public companies are those
without a maximum limit on the number of shareholders but required to have a minimum of seven
shareholders to be allowed to operate. These companies can be listed on the stock exchange, as their
shares are freely transferable. In this respect, they are required to issue a prospectus, which is an
invitation to the public to subscribe to shares on issue. It is these types of corporations that are listed on
the Dar es Salaam stock exchange.
The third category of companies recognised under rRELA is foreign companies, these are companies
operating in Tanzania as branches of companies incorporated outside Tanzania. They are not viewed as
Tanzanian companies. The final category of company is a form of private company in which the
government holds more than 50% of the voting shares. The Corporations Act of 1992 applies to these
corporations. This form of corporation was the most significant between 1967 and 1992 but is currently
diminishing as privatisation continues.

 cãã

Tanzania is a developing economy with agriculture its mainstay. Other sectors of the economy are
gradually beginning to make a important contribution to the economy. Two systems of economic
coordination have existed in this country over the past forty-three years of independence: a centrally-
coordinated system and then a market-based system. The developments in 1967 led to the adoption of
policies that sought to encourage the evolution of an egalitarian society based on state-ownership of the
major means of production including corporations.
Developments in the late-1980s have changed the course of events. The economic reforms that were
introduced in 1986 have the objectives of promoting and encouraging competition, and reducing the
role of the state in economic activities giving individualism more room to thrive. This type of economic
coordination is advocated in classical/neoclassical liberalism. The implications of such change for
corporate governance is the evolution of large shareholders. The majority of privatised corporations
have controlling shareholders. The company ordinances (Cap. 212), currently provide the framework in
which corporations are governed. This framework promotes a liberal, shareholder oriented system of
corporate governance. This is for the reason that the framework recognizes shareholders only in the key
decision-making organs of the corporation: annual general meetings and boards of directors.
Mergers and takeovers have introduced a new dynamism into the U.S. economy, producing gains from
increasing incentives for efficiency improvements. Management is challenged to demonstrate
continuing value increasing contributions to shareholders. rut many examples of mistakes and excesses
can also be cited.

The merger movement at the turn of the century was followed by economic development and growth in
the U.S. M&As in the 1980s have also been associated with a long period of economic expansion.
Obviously M&As have not been the only significant economic factor operating. rut neither have they
been a major negative or destructive force to date.

"9":<c"ãã
1. Discuss the current issues in corporate finance of Tanzania.
2. What is pension fund management? How it is beneficial both to employees and enterprises?
3. State the differences between defined contribution pension funds and defined benefit pension
funds.
4. What is leveraged buyout?
5. State the reasons for which the listed firms go private.
6. How the executive compensation plans are beneficial?
7. How will you justify the corporate restructuring and control?
8. What are the benefits of mergers and acquisitions?
9. State the difference between split-off and spin-off with suitable examples.
10. What do you mean by conglomerate mergers?

¢ã"ãc;
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An environment of integrity is essential for private sector development, promotion of foreign
investments and economic growth. Its requirements include building an anticorruption environment,
provision of high quality government services, predictability and consistency of government procedures
and regulations, and overall transparency of the system. Increasingly, many African countries are now
realising that capable and responsible governments are a prerequisite for development.
All over, initiatives are underway to reduce bureaucratic delays and uncertainties in servicing the
business sector and in ensuring integrity, rule of law, transparency and regulatory consistency to all.
Maintaining high level of Integrity and transparency correlates with creating a favourable environment
for private sector growth and Investment. If African countries are to meet the Millennium Development
Goals (MDGs) both; governments and businesses need to share responsibility in any drive to create a
eliminate corruption free in integrity environment that will automatically improve investment
environment levels and quality.
The reverse is true. Corruption for instance, can and does sabotage national development. Corruption
leads to a loss of government legitimacy and of public trust and support. It inhibits the functioning of the
market and distorts the allocation and use of resources, hence hampering trade and deterring
investment. Corruption is often a collusive arrangement between some officials in government and
individuals in business who have little or no concern for the social, economic, environmental, political or
human consequences of their actions. Such decisions are taken not for the public benefit but merely to
serve personal interests.
Many countries in this era of democracy and transparency have intensified efforts at deepening reforms
in service delivery institutions such as the judiciary, parliament, local government, public service
management, etc. Progress has been achieved in many African countries though the journey ahead is
long and difficult. Lack of an integrity environment impedes FDI flows too. Many African countries are
pursuing market oriented economic policies, including divestiture of public enterprises, and creating an
environment more conducing for business. This includes improving efficiency in production and service
delivery. Yet the business environment overall is not yet fully conducive for FDI inflows.
As per Transparent International report 2004 as well as the findings by the Economic Commission for
Africa (ECA) study on governance, most of African countries performed badly in efforts to control
corruption and creating integrity environment. There is a clear need to create and nurture an integrity
environment which will prevent corruption and create a better environment for private sector
development and investment promotion.
"""¢¢ "9" * "ã
The International community recognising the detrimental effects of corruption on development, has
endorsed the UN Convention against Corruption. The Convention enhances cooperation and mutual
legal assistance, particularly regarding return of stolen assets. As more and more countries ratify the
Convention, corrupt practices in a foreign country are no longer beyond the reach of domestic
jurisdictions. For Africa the adoption of African Union Convention on Prevention and Combating
Corruption and Related Offences was a most important development. Nevertheless, as reported by
Transparency International, the major weakness of the Convention is that it permits any signatory to opt
out of some or all provisions!
Under the NEPAD/African Union Programme, 24 African countries representing about 75% of the
continent͛s population have agreed to take part in peer reviews of their governance performance ʹ
African Peer Review Mechanism (APRM). Countries that endorsed APRM must conform to agreed values
in four areas including, democracy and political governance, economic governance, corporate
governance and socio-economic development. Tanzania is amongst African countries that endorsed the
APRM. Nevertheless the success of creating an integrity environment and fight against corruption
depends on commitment and political will to implement change.
".;¢..9"¢"A#"c"ãc¢(ã¢cã¢ã¢ã)
¢D¢¢
͞We have persisted in our resolute struggle against corruption, including through rolling out plans to
combat corruption; the establishment of anti-corruption bureaus at the district level; and enhanced
accountability for resources transferred from the Central Government to the district level. Tanzania͛s
efforts in fighting corruption are starting to win international recognition.͟
(His Excellency President renjamin W. Mkapa addressing the 4th International Investors͛ Round Table
(IRT) meeting at the Golden Tulip Hotel, 23rd November 2004)
r
 
Tanzania like many other Sub-Saharan Africa countries achieved its independence with a severely
underdeveloped economy and extremely limited infrastructure. Nevertheless, Tanzania has made
concerted efforts to improve its economy, raise living standard of its people and create a conducive
environment for private sector development & investment. Since early 1980s, governments of
developing countries have been supporting and implementing strategies of encouraging competitive
free markets, privatisation of state owned enterprises (parastatals), move from closed (no trade) to
open (trading) economies and opening up the domestic economy through free trade and attracting
foreign direct investment. This was done as a way of recognising the lead role that private sector can
play in economic development. The private sector expressed concern that the system of governance in
the region is still tinged with corrupt practices. According to the Transparency International͛s annual
Corruption Perception Index (CPI) for 2003, out of the 133 countries that were surveyed, the East
African countries of Kenya, Uganda and Tanzania ranked relatively high in levels of corruption. The
rankings were 122 for Kenya (with a CPI score of 1.9 out of 10), 113 for Uganda (with a CPI score of 2.2
and 92 for Tanzania (with a CPI score of 2.5).
In all the three countries, efforts are being taken to curb corruption as systems are made to become
more transparent with better placed to apply the rule of law in government operations. Nevertheless, a
recent PWC report has suggested that the war on corruption in East Africa is being lost for the reason
that of lack of political will in the high echelons, inadequate funding and equipment for anti-corruption
institutions, an inappropriate legal framework and lukewarm enforcement as most bureaucrats who are
charged with the responsibility of fighting corruption are themselves corrupt.
 

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Ͷ H.E. President renjamin W. Mkapa at the launch of PSRP on June 20th 2000.

In most African countries including Tanzania corruption was at a relatively low level during͛ colonial rule.
Nevertheless, after independence and the move to single party systems, which concentrated power into
small cliques corruption, began to rear its ugly head. As time passed, the integrity environment became
dramatically eroded.
In order to foster integrity environment and create a better environment for investment and private
sector development, the Tanzania government has taken several steps. First, in 1991, the government
set up the Prevention of Corruption rureau (PCr). In 1995, the government formed the Public
Leadership Code of Ethics to curb impropriety at higher levels of public service and later it established
the Commission for Human Rights and Good Governance (2001). In reality the government was
preparing the legal framework to curb corruption and bring about integrity in public service. Later, the
government established the Permanent Commission of Inquiry (Ombudsman) in 1996 to check abuse of
power by government officials and its agencies.
When, President renjamin William Mkapa came into power in 1995, he declared war on corruption so
as to enhance the integrity environment. As a first step he established the Presidential Commission
Against Corruption in January 1996. Ten months later, the Commission produced one of the most
respected and commended analyses of corruption by any Africa state (commonly referred to as the
Warioba Report). The report identified areas/environments where corruption occurs and also revealed
regulations and procedures that facilitate corruption. It also cited examples of dubious
decisions/contracts in several departments that were perceived corrupt.
The Warioba report concluded that there was much evidence of Corruption. The report classified
corruption into two categories. The first type relates to those who receive bribes to cater for their daily
living needs (Petty Corruption) while the other group involves high level leaders and public officials, who
are motivated by excessive greed for wealth accumulation and money (Grand Corruption). The Warioba
Report had the further benefit of opening up public discussion on corruption.
Accordingly, the government took several measures to address the problem. Such measures include: -
! Appointment of a good governance Minister, who is responsible for among other things in
monitoring overall strategy & implementation of anti-corruption measures,
! Adoption of Natural Anti-Corruption Strategy for Tanzania. The strategy focuses on the need for
transparency and accountability in government,
 ! Appointment of the Prevention of Corruption rureau (PCr). This is a unit that investigates and
prosecutes corruption with the approval from the Director of Public Prosecutions (DPP),
! Establishment of the Commission for Ethics to deal with administering and enquiring into senior
public appointee͛s Declaration of Assets and making recommendations to the president.
Along with above measures, which were implemented simultaneously with other government reform
measures, Tanzania took holistic strategic approach to improve its governance system as reflected in
͞The National Framework on Good Governance, (NFGG) (Dec, 1999). This framework gave rise to the
Accountability, Transparency and Integrity (ATIP) programme.
This programme aims at supporting NFGG through: -
! Strengthening the legal and judiciary system,
! Enhancing public financial accountability,
! Strengthening oversight and watchdog institutions.
The Public Sector Reform Programme of Tanzania, which was officially launched by His Excellency, the
President of the United Republic of Tanzania in June 2000 aims to transform the public service into a
result-oriented public service. Among other things, it aims to create a public service of the high calibre
and integrity that is both responsive to and supportive of national efforts to deliver service to be
competitive, to ensure good governance and to facilitate poverty reduction. The PSRP has been
designed in pursuit of the vision, mission, core values and guiding principles that have been
promulgated in the new public services management and employment policy. Major structural and
institutional changes had been effectively implemented by the end of the PSRP phase of Government
reform. These changes may be highlighted under the following seven headings:
! Contracting and streamlining of Government structures;
! Reduction in employment numbers and wage bill control;
! Installation of an integrated Human Resources and Payroll Management system;
! Improved pay structure and enhanced salary levels;
! Restructuring and decentralisation for improved service delivery;
! Capacity building; and
! Improved policy and legislative environment for sustaining reforms.
The president speaks frequently on his determination to fight corruption. Nowadays there is the greater
awareness of the evil effects of corruption, which are being openly discussed. Previously, some of the
greatest obstacles to curbing corruption were weak political will, weak institutions, and inadequate
adherence to the rule of law, entrenched patronage, weak Private sector and weak civil society.
 

" 

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 +

In recognition of the necessity to build an integrity environment hand in hand with economic reforms,
Tanzania took several measures such as:
! Tax reforms aimed at streamlining the tax structure, broadening the tax base, and establishing a
sound institutional framework (establishment of TRA and introduction of Value Added Tax
(VAT), in 1997.
! Parastatal sector reforms through privatisation of state owned companies and institutional
reforms. The government adopted privatisation programme whereby about more than 80% of
400 public entities that existed prior to 1993, had been divested by the end of 2003.
! In 1999 commercial courts were established to speed up hearing of commercial disputes thus
building investors͛ confidence.
! Public Service Reforms; which introduced client service charters in all its ministries and agencies.
President͛s Office assists departments and agencies to prepare the charters. These charters are derived
from or are part of mission statements and focus on what the institution sets out to do for its
customers. Charters increase accountability by setting performance standards. There are consequences
when standards are consistently not achieved. Embedded in the charters are annual incentives such as
awards to best performing workers and institutions. In addition, courses on public service customer care
and anticorruption are being run by the department of Good Governance in the President͛s Office to
enhance service excellence, and adherence to a code of moral or ethical values including incorruptibility.
! Financial sector reforms have been achieved by way of privatisation of state owned banks,
allowing foreign banks to operate alongside local banks, establishment of the Capital Market
and Securities Authority (CMSA) and setting up of the Dar es Salaam Stock Exchange (DSE).
! Establishment of the Tanzania Investment Centre (TIC) with expanded mandate as ͞one stop
centre͟ to promote and facilitate all investments and to advise the Government on investment
matters. To minimize bureaucracy, the investment code also set a maximum period of 14
working days within which relevant government agencies were to have processed applications
sent to them by TIC and that ͞where the Centre does not receive a written objection from the
relevant authority within the specified time, the necessary license or approval shall be deemed
to have been granted
! Formation of the National Investment Steering Committee headed by Honourable Prime
Minister. The Committee is entrusted with the task of investment policy formulation and solving
intersectoral problems of investors on a fast track basis. Again this initiative was put in place to
provide further momentum to the investment process in Tanzania.
Other measures taken to improve economic governance in summary were,
! Implementation of an integrated Financial Management System;
! Adopting an inclusive Public Expenditure Review/Medium Term Expenditure Framework
process;
! Establishment of a commercial court ʹ as stated earlier.
! Revision of Public Finance Management and Public Procurement Act;
! Legal sector reform programme (LSRP)
! Local Government Reform Programme;
In Tanzania, there is in place a National Anti-Corruption Strategy and Action Plan (NACSAP), which
basically brings together a coalition of stakeholders (public/private) to combat corruption.
The NACSAP is envisaged to improve the quality of public service delivery through the following ways: -
! Effective and transparent system of procedure and regulations.
! Enhance and organizational capacity to deliver high quality standard of service.
! Public awareness on procedures, standards of services, codes of conduct and their rights in
general.
Inputs for the NACSAP emanate from the key three stakeholders namely the Government, civil society
and the private sector. This relationship is critically significant in the fight against corruption, No
anticorruption strategy can succeed without the joint efforts of government, civil society and business.
Thus, nurturing this relationship is vital in the fight against corruption.
 
  h ' 
Tanzania has made major progress over recent years towards putting into place a policy environment
for investment promotion. Increase investment flows are a sign of an improving integrity environment.
Government priorities have included stable macroeconomic environment, privatization, promoting good
governance and elimination of corruption, building a democratic nation, poverty eradication and
development of a strong civil society.
Policy reforms like trade liberalization, financial sector reforms, local government reforms, legal sector
reforms, tax reforms, decentralization, civil services reforms and enforcing accountability and measures
against corruption, have enabled Tanzania to improve efficiency and to increase economic growth and
FDI inflows. The government has been fully supportive of public/private dialogue institutions. In this
respect the Tanzania National rusiness Council (TNrC) was established and has provided a forum for
public/private sector dialogue to improve business environment in the country. Its membership is 50%
public and 50% private with President as Chair while the Vice Chairman is Chairperson of the Tanzania
Private Sector Foundation. The Council addresses investment issues affecting domestic and foreign
investors through respective Round Table meetings at which government͛s service delivery is called to
account, with cabinet ministers attending. The Government has in addition, embarked on the
implementation of a programme of rusiness Environment Strengthening for Tanzania (rEST). The
purpose of the programme, whose implementation started in December 2003, is to reduce the burden
of businesses by eliminating as many procedural and administrative barriers as possible and to improve
the quality of services provided by the government in the private sector including commercial disputes
resolution. The five-year rEST plan shows that the targets will be achieved through five inter-linked
components (rox).
rã
  

    r *



     R


Achieving retter Regulation ! Unnecessary regulations removed
! Sustainable process established for
ensuring business friendly laws,
regulations and administrative
procedures
! Improved efficiency and
transparency of government
institutions dealing with business
Improving Commercial Dispute ! Improved accessibility to the court
Resolution system for formal and informal
business
! Speed and quality of service
provided by court system for
business improvement
Strengthening the Tanzania ! Increased number and value of
Investment Centre local and foreign investment in
Tanzania
! Enhanced promotion of Tanzania as
investment destination
Changing the Culture of ! Improved customer service ethos
Government for services provided to the private
sector by the public and judicial
service
Empowering Private Sector ! Improved capacity of private sector
Advocacy stakeholders to identify regulatory
problems and solutions and
advocate for an improved business
environment
Source:
á+r
 


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- 122',

The progressive increase in FDI stock and flows revealed in figure 1, correspond with the investment
policy evolution and promotional efforts that the Government undertook since early 1990s as discussed
in the previous section. It is evident here that investors are sensitive to domestic policy actions. After
the establishment of IPC in 1990, for example, the volume of FDI at first rose sharply and then stagnated
after 1995 in response to administrative weaknesses in the IPC.

h

: shows considerable rise in annual FDI flows between 1990-2004 and a continuous increase in
annual FDI stocks from 1998-2004.

Key: eMrOT estimates; pMrOT projections

Source: O+-../,
-..2-..-r )
-..11220.
Tanzania has generally acquired a sound reputation internationally. For instance, in April 2004, Tanzania
was rated by UNCTAD survey of as the 2nd most attractive destination in Africa, just behind South
Africa. In 19th November 2004 Tanzania Investment Centre was chosen as the Africa͛s best Investment
Promotion Agency of the year (2004) by Africa Investor Media Group, (http\\www.Africa-
investors.com).
$   

" 

   ..
 
   *

 
As per the Warioba Report and other surveys on corruption and improving integrity such as the study
͞Striving for Good Governance in Africa͟ done by UN - Economic Commission for Africa (ECA), it has
been revealed that although constitutional government is getting stronger and more democratic,
countries perform badly in efforts to control corruption and building an integrity environment. For
instance corruption is rampant in the tax systems, police and the judiciary. The ECA study released in
October 2004 showed that in many African countries police and the military violate the rights of
civilians, electoral commissions need more independence, and costs and red tape greatly hinder
business and investment activities in Africa.
The report identifies 10 areas in need of urgent action including strengthening parliaments, protecting
the autonomy of the judiciary, improving the performance of the public sector, supporting the
development of professional media encouraging private investment and decentralizing the delivery of
services.
On the other hand, the UNCTAD Study on Good Governance in Investment Promotion and Facilitation
(2002), major obstacles to Good Governance in Investment Promotion are: -
! Limited infrastructure, and institutional capacity
! Capital resources/financial constraints,
! Skills and education,
 ! Transportation,
! Legal system and crime,
! rureaucracy and corruption,
! Institutionalised negative mindset.
As per the TIC/roT/NrS investment survey (2003) on investors͛ perceptions on Good Governance,
results show that seven out of eleven factors had negative effect and only four were rated favourably
(Figure 2). Factors considered included bureaucracy, corporate corruption, custom procedures, domestic
political stability, legal system, internal security, investment facilitation, public sector corruption,
regional political stability, speed of government decision-making and tax collection efficiency.
h

4  
@*

  *

 .
 h


Regional and domestic political stability, investment facilitation, internal security, are four out of eleven
factors that were positively rated (Figure 2). On the other hand, factors that were negatively rated
include; bureaucracy, corruption, effectiveness of the legal system, customs procedure, tax collection
efficiency and speed of Government decision-making process. All these factors though rated negative,
have been improving between ͞start-up͟ and 2003 periods. Reasons behind the improvements include,
among others, the sustained efforts by the Government on the fight against corruption as well as
reduction of bureaucracy by transforming the speed of Government decision-making process.

#"""h*¢".9"¢"
As the private sector is increasingly becoming a key partner in development in many African countries,
the importance of creating better environments for private sector development is critical. Similarly, in
order to build integrity and attract both local and foreign investors, the private sector has to accept, and
implement Corporate Governance. As a recent World rank report stated, ͞Corporate Governance is
concerned with holding the balance between economic and social goods and between individual and
communal goals, the aim being aligning as nearly as possible the interest of individuals, corporations
and society.͟
In many African countries nowadays, corporate governance has become a critical element of business
management and economic growth. Elsewhere, massive economic crises and corporate failures have
been closely associated with the lack of good corporate governance. Lack of sound corporate
governance has fuelled corruption and cronyism while suppressing sound and sustainable economic
decisions. Results from some surveys carried out, demonstrated that there is a positive correlation
between good corporate governance and increasing capital flows. It has been suggested that good
corporate governance reduces cost of capital as it provides a positive global premium that tends to
attract investment. Pillars of corporate governance include transparency, accountability, probity and
respect for the rights of all stakeholders.
The OECD Principles on corporate governance (2004) constitutes a balanced benchmark for corporate
governance. The Principles are intended to assist OECD and non-OECD governments in their efforts to
evaluate and improve the legal, institutional and regulatory framework for corporate governance in
their countries, and to provide guidance and suggestions for stock exchanges, investors, corporations,
and other parties that have a role in the process of developing good corporate governance. They also
provide the basis for an extensive programme of cooperation between OECD and non-OECD countries
and underpin the corporate governance component of World rank/IMF Reports on the Observance of
Standards and Codes (ROSC). Nevertheless, as the world is becoming smaller and smaller and with
increased globalisation, companies/corporations worldwide cannot escape from the global movement
that shapes standard principles of corporate governance. Tanzania has so far developed her own
national code of corporate governance.

#":¢;h:¢
Though in many African countries, leadership has have done much to advance their national economies
over the past decade nevertheless much remains to be done, as overall economies are small and
underdeveloped. There is no conducive environment for investment promotion and economic growth.
Good governance and enhanced Integrity environment as pillars to better economic and investment
climate are yet to be achieved. Many countries are perceived to be corrupt as the political will to
counter corruption is perceived as lacking. It is true in many countries that there is ͞much talk͟ but little
real action against corruption.
African Leaders have to institute and promote good governance and integrity environment as a
foundation for creating a favourable investment climate. Government operating an integrity
environment creates willingness in people and the business community to trust and cooperate. Courage
is of utmost importance in maintaining integrity. Without strong, clear leadership and support
throughout the government, its various departments and the law enforcers, it is very difficult for any
real advance in the fight against the evils of corruption to succeed.
Government and corporate leaders must: -
! Live and openly role-model integrity in all their dealings,
! Make morally and ethically correct decisions regardless of cost or difficulty,
! Hold on to the vision and of clean government and clean business,
! re courageous in sharing their sentiments and recommendations,
 ! Have clear values to guide them so as to take bold decisions,
! Have the courage of owning their mistakes and learning from them.
All African Countries must rectify the African Union Convention on Prevention and Combating
Corruption and Related Offences to remove avoidance clauses. The must also agree to take part in peer
reviews of their governance performance. Measures like strengthening the legal and judiciary system,
enhancing public financial accountability and strengthening oversight and watchdog institutions are
critical in promoting integrity environment.
Another significant factor in promoting good governance is public awareness on procedures, standards
of services, codes of conduct and their rights in general. Information regarding services provided by
Ministries, Departments and Agencies should be spelt out clearly in the client charters and disseminated
freely. Success in creating an integrity environment for investment promotion and economic growth
depends on commitment and political will to implement necessary reforms as recommended.
Finally, WITHOUT GENUINE COMMITMENT ʹ ALL IS LOST!!
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: http://www.oecd.org/dataoecd/11/37/34571058.pdf
< 
 :
1. Do you agree with the words ͞WITHOUT GENUINE COMMITMENTʹALL IS LOST!!͟ in case of
Tanzanian Corporate Governance? Write your views.
2. What other factors except those discussed in the above case study can be implemented to
promote good governance in the Tanzania?