Article Review

Corporate Capital Budgeting and CEO Turnover

Author: Abigail S HornsteinJournal of Corporate Finance 20

(2013) 41-58

Universiti Teknologi MalaysiaInternational Business School

Accounting and Finance for Decision Making(PBSA 1423)

October 2014

Student: Kevin Koo Seng Kiat

Previous Studies

Many studies have found that Quality of a Firm's Performance varies markedly before and after CEO turnover.

Previous Studies

● Corporate budgeting decisions most effective when Agency & Informational asymetry problems minimized; linked to strong internal communication channels.

● CEO turnover may indicate agency / informational asymmetry problems; may be linked to change in internal communication channels.

Previous Studies

● Increase of agency / informational asymmetry problems cause CEO's to believe they will depart company soon (CEO Turnover).

● Such CEO's focus on short-term performance.

● This impairs quality of corporate budgeting decisions.

Previous Studies

● CEO idiosyncratic behaviour influences level & quality of corporate investments & capital budgeting decisions.

● CEO's idiosyncrasies influences whether he invests more or less; to maximize shareholder value, avoid risk, etc. These can be traced to agency problems.

Focus of Paper

● Author studies efficiency (profitability) of corporate capital budgeting in years before & after CEO turnover.

● The link to firms' prior tendency to over- or under- invest is also studied.

● Many firms over-invest prior to CEO turnover, halt investments in the period of the turnover, and increase expenditures after the CEO turnover.

Methodology

● Empirical analysis of cross-sectional and inter-temporal variation in quality of firms' corporate budgeting decision used

● Inter-temporal variation: Studies influence of firm's CEO on capital budgeting decisions.

● Empirical approach: Examines nature of corporate capital budgeting decisions during period of CEO turnover.

Methodology

● Marginal q analysis used to rate value of firm's marginal investments.

● Marginal q is ratio of unanticipated incremental change in firm market value over contemporaneous marginal investment.

3 scenarios

● Marginal q analysis based on 3 scenario:

● #1: Managerial tenure entrenches individuals, insulates invidual from poor investment decisions.

● #2: CEO with higher level of managerial skills have greater reputational capital,and more employment opportunities. They are less opportunistic & more conservative .

● #3: Powerful CEO will have maintain more opaque information environments; firms face higher cost of debt and lower firm value.

Data / Sample

● Period of CEO turnovers examined: 1992-2002.

● Data examined from 1989 to 2005 to allow analysis of 3 years before and after CEO turnover.

● Independent variables: Marginal q estimates (data from 1989 to 2005), firm and CEO characteristics (data from 1989 to 2004)

● Data includes 766 CEO turnovers sourced by combining & filtering several databases. Filtering process included companies with tangible assets of more than $1 million, but excluded real estate & insurance firms, etc.

3 rounds of Analysis

● #1: Only firm characteristics are included to identify inter-temporal variation in how firm characteristics influence quality of firm's corporate capital budgeting decisions.

● #2: Include characteristics of incumbent and newly appointed CEO's during years they were in charge of the firm.

● #3: Corporate governance variables also included to capture possibility that firm's governance and firm performance may induce subsequent changes in one or both variables.

3 rounds of Analysis

● Each round of testing is done twice using different values for “optimal” threshold benchmark value of marginal q: (a) 1.0 following theory; and (b) 0.78 following back-of-envelope experiment.

Findings

● Firms have sharply improved asset allocation when agency problems are minimized

● Under- and over- investing firms should be analyzed separately as impact of firm characteristics and board governance is not constant

● Intertemporal analysis reveals that boards take time to effect change; CEO turnover often trails periods of less efficient capital budgeting decisions by several years.

Findings

● Baseline results:

1. Average Tobin's Q positive and highly significant for under-investing firms in almost all time windows

2.In pre-turnover years, larger firms make more efficient corporate capital budgeting decisions.

Findings

● CEO Characteristics results:

1. Outsider CEO has no impact on firm's corporate capital budgeting decisions.

2.CEO's departure may be forced by the board when over-investing prior to turnover.

3.Entrenched CEO's do not appear to make less efficient capital budgeting decisions.

Findings

● Corporate governance model:

1. Quality of firm's corporate capital budgeting decisions strongly affected by characteristics of board of directors.

Review

● This paper is quite innovative in its use of marginal q analysis, through cross-sectional and time series analysis.

● The author concludes that forced turnover follows marked over-investment

● Author also concludes that there are clear and sustained differences between firms that over- and under- invest.

Review

● The paper may have been more useful if it had discussed CEO Turnover in relation to over- and under- investing firms, in depth.

● The classification of over- and under- investing firms may be unnecessary.

● For person with lack of background in this area the use of marginal q and Tobin's Q appear to be too confusing.