Common Shareholders Research Articles

Neural network techniques for financial performance prediction: integrating fundamental and technical analysis

This research project investigates the ability of neural networks, specifically, the backpropagation algorithm, to integrate fundamental and technical analysis for financial performance prediction. The predictor attributes include 16 financial statement variables and 11 macroeconomic variables. The rate of return on common shareholders' equity is used as the to-be-predicted variable. Financial data of 364 S&P companies are extracted from the CompuStat database, and macroeconomic variables are extracted from the Citibase database for the study period of 1985–1995. Used as predictors in Experiments 1, 2, and 3 are the 1 year's, the 2 years', and the 3 years' financial data, respectively. Experiment 4 has 3 years' financial data and macroeconomic data as predictors. Moreover, in order to compensate for data noise and parameter misspecification as well as to reveal prediction logic and procedure, we apply a rule extraction technique to convert the connection weights from trained neural networks to symbolic classification rules. The performance of neural networks is compared with the average return from the top one-third returns in the market (maximum benchmark) that approximates the return from perfect information as well as with the overall market average return (minimum benchmark) that approximates the return from highly diversified portfolios. Paired t tests are carried out to calculate the statistical significance of mean differences. Experimental results indicate that neural networks using 1 year's or multiple years' financial data consistently and significantly outperform the minimum benchmark, but not the maximum benchmark. As for neural networks with both financial and macroeconomic predictors, they do not outperform the minimum or maximum benchmark in this study. The experimental results also show that the average return of 0.25398 from extracted rules is the only compatible result to the maximum benchmark of 0.2786. Consequentially, we demonstrate rule extraction as a postprocessing technique for improving prediction accuracy and for explaining the prediction logic to financial decision makers.

Decision Usefulness of Alternative Joint Venture Reporting Methods

Depending on the country and circumstances, reporting rules for intercorporate investments may require the cost method, the equity method, proportionate consolidation, or full consolidation, and may yield dramatically different accounting numbers. In the post-Enron environment there is a particular focus on investments for which liabilities remain off balance sheet. We compare the information content of alternative accounting treatments for a sample of Canadian firms reporting joint ventures under proportionate consolidation. We restate their financial statements using the equity method, and we compare the information content of the two accounting methods in predicting accounting return on common shareholders' equity. We find evidence consistent with the view that financial statements prepared under proportionate consolidation provide better predictions of future return on shareholders' equity than do financial statements prepared under the equity method. We conclude that, for these firms, proportionate consolidation provides information with greater predictive ability and greater relevance than does the equity method.

Dividend Policy Inside the Multinational Firm

This paper analyzes dividend remittances by a large panel of foreign affiliates of U.S. multinational firms. The dividend policies of foreign affiliates, which convey no signals to public capital markets, nevertheless resemble those used by publicly held companies in paying dividends to diffuse common shareholders. Robustness checks verify that dividend policies of foreign affiliates are little affected by the dividend policies of their parent companies or parent company exposure to public capital markets. Systematic differences in the payout behavior of affiliates that differ in organizational form, and those that face differing tax costs of paying dividends, reveal the importance of tax factors; nevertheless, dividend policies are not solely determined by tax considerations. The absence of capital market considerations and the incompleteness of tax explanations together suggest that dividend policies are largely driven by the need to control managers of foreign affiliates. Parent firms are more willing to incur tax penalties by simultaneously investing funds while receiving dividends and to regularize dividend payments when their foreign affiliates are partially owned, located far from the United States, or in jurisdictions with inefficient judicial systems, all of which are implied by control theories of dividends.

Proportionate Consolidation vs. the Equity Method: A Decision Usefulness Perspective on Reporting Interests in Joint Ventures

The number of joint ventures, and the number of industries in which joint ventures are commonplace, have expanded considerably over the past twenty years. The prescribed treatment for accounting for interests in joint ventures varies across nations, with some requiring the equity method (e. g., the United States) and some requiring proportionate consolidation (e. g., Canada). A 1999 report by the G4+1 recommends that venturers use the equity method to account for interests in joint ventures, but cautions that there is very little empirical evidence on the decision usefulness of one approach over the other. This paper provides empirical evidence on this question by analyzing the financial statements of Canadian firms reporting joint ventures over the period 1995-2000. Our results show that ratios calculated from proportionately consolidated venturer financial statements are more useful in predicting one-, two- and three-year-ahead return on common shareholders' equity than are ratios calculated from venturer financial statements prepared under the equity method. We conclude that, at least for this set of firms, proportionate consolidation provides information with greater predictive ability and, therefore, greater relevance to financial statement users than does the equity method.

Financial accounting return on investment and financial leverage

This note presents a method for teaching the concept of financial leverage and its relationship to accounting rates of return. Typically, financial leverage is only briefly mentioned in introductory accounting textbooks, and it is rarely related explicitly to rates of return on total assets and on common stockholders' equity. Yet the concept is an important one for financial managers. We have developed and class tested a numerical illustration to explain in a conceptually sound manner why the two rates of return differ. Accounting instructors who share our view that financial leverage should be covered more thoroughly in the introductory accounting course will find this example to be a useful supplement. The example can also be used as a way to develop critical thinking skills or to enhance a user orientation.

Venture Capital on the Downside: Preferred Stock and Corporate Control

This paper examines the law and economics of downside arrangements in venture capital contracts. Downside protection for a venture capitalist means two things-first, power to replace the firm's managers (or alternatively, to force sale or liquidation of the firm), and, second, power to protect the venture contract itself from opportunistic amendment. Recent empirical work by Kaplan and Stromberg shows that venture capital investments possess this protection in varying degrees, depending on the mode of their participation and the governing contracts' terms. The venture capitalist remains vulnerable in a significant number of cases, lacking voting and boardroom control and relying entirely on terms articulated ex ante in the preferred stock contract. In these cases, there arises a risk of exposure to issuer opportunism in downside situations. The paper evaluates this risk, reviewing contract terms employed in venture capital transactions and the caselaw on preferred stock. A mixed picture emerges. The terms of venture capital contracts improve in significant respects on those of traditional preferred stock contracts. But they are not perfect and offer incomplete protection from issuer opportunism. Meanwhile, the caselaw is as hostile as ever. Delaware has taken the lead, sustaining a classic case of preferred stock victimization in a venture capital context. The paper criticizes this approach as a matter of both contract law and contract economics. Contract law's good faith duty can be used to protect venture capital preferred without a cognizable risk of unproductive judicial interference in corporate affairs. Furthermore, under the economics of incomplete contracts, where subject matter is noncontractible a blanket presumption against ex post intervention on the ground of forced contract is incoherent. Drawing on the control transfer model of Aghion and Bolton, the paper shows that efficient results and the interests of senior securityholders are aligned in a larger set of cases than previously supposed. Accordingly, when disputes between venture capitalists and entrepreneurs come to court, a rote presumption favoring the common stockholder is not defensible on efficiency grounds.

Leveraged Closed-End Equity Funds

Since 1996, a handful of closed-end equity funds have issued non-convertible preferred stock to raise additional capital. Because of favorable long-term interest rates and a 1989 tax ruling stipulating that distributions of investment company income and capital gains must be allocated proportionately to preferred and common shareholders, this form of leveraging has become particularly appealing. This article review the different ways close-end funds can raise capital. It analyzes the concept and risks of leverage, examines the history of leveraged close-end municipal bind funds, and then focuses on the use of leverage by equity funds. While preferred leverage can enhance long-run returns, it also increases risk and may pose problems for manager in bear markets. S&P 500 rolling five-year returns are analyzed over the 1945-1998 period to determine the potential impact of leverage during favorable and unfavorable markets.

The sensitivity of CEO wealth to equity risk: an analysis of the magnitude and determinants

To control risk-related incentive problems, equity holders are expected to manage both the convexity and slope of the relation between firm performance and managers’ wealth. I find stock options, but not common stockholdings, significantly increase the sensitivity of CEOs’ wealth to equity risk. Cross-sectionally, this sensitivity is positively related to firms’ investment opportunities. This result is consistent with managers receiving incentives to invest in risky projects when the potential loss from underinvestment in valuable risk-increasing projects is greatest. Firms’ stock-return volatility is positively related to the convexity provided to managers, suggesting convex incentive schemes influence investing and financing decisions.

RATIONAL TIMING OF CALLS OF CONVERTIBLE PREFERRED STOCKS

AbstractConversion‐forcing calls of convertible preferred stocks are re‐examined focusing on the value of the conversion option impounded in the preferred price. This amount represents the preferred shareholder wealth potentially transferable to common stockholders. Capture of this wealth underlies the theoretical motivation for calling and forcing conversion as soon as possible. Most of the preferred issues examined exhibit nonpositive average option values throughout all but short periods; hence, no wealth transfer opportunity exists for immediate calls. Issues that exhibit positive option values are called quickly. In contrast to interpretations that have persisted for over fifteen years, our results reveal no substantial delays in calling convertible preferred stocks.

AN INVESTIGATION OF PREFERRED STOCK FINANCING BY BANK AND NONBANK FINANCIAL INSTITUTIONS

AbstractWe investigate the shareholder wealth effects of announcements of preferred stock issues made by financial institutions. Fixed‐rate straight preferred stock and convertible preferred stock issue announcements result in insignificant common share price responses. However, the average stock price reaction to announcements of adjustable‐rate preferred stock issues is positive and significant for banking firms. Our findings suggest that banks' common shareholders react positively to adjustable‐rate preferred stock issue announcements because such securities provide a relatively low‐cost way of increasing the primary capital used to satisfy legal minimum capital requirements without diluting common equity voting rights.

The Cost of Bond Covenant Restrictions on the Disposition of Assets

The cost of bond covenants restricting the dispositions of assets are examined in this study. Using an option pricing framework, it is shown that the cost of compliance could be high if restrictions are placed on the sale of common stock holdings. Similar results can be obtained by using a simple cash flow approach when calculating the effect on restrictions on the sale of depreciable assets. These costs somewhat offset the tax advantages of debt.

Characteristics of Common Stock Holdings of Insurance Companies

This article investigates the stock market portfolios of insurance company portfolio managers and compares the characteristics of their equity holdings with those of other (noninsurance) institutional equity portfolios. The main finding is that the cross-sectional determinants documented by earlier researchers for aggregate institutional ownership levels in firms do not have the same explanatory power for levels of ownership of insurance companies. On the other hand, these same firm characteristics have significantly high explanatory power regarding the decision of insurance companies to invest in a firm.

Do Investors Price Social Responsibility?

In the past few decades society has placed increasing demands on managers of firms to change corporate policy and to make decisions in ways that are deemed socially responsible by society. The scope of activities under the corporate social responsibility umbrella has in cluded environmental issues, the involvement of women and minorities in management, investing in South Africa, pollution control, ethical treatment of animals, nuclear testing and other related issues. Society's demands in these areas have inspired (and in some cases even coerced) both managers of corporations and portfolio managers of investment funds to respond. Many of the leading mutual fund investment companies now offer funds that are ethically screened. The Society Investment Forum reports that the value of socially responsible investment funds exceeded $600 billion by the end of 1991. A new stock index, the Domini 400 Social Index, has been constructed to measure the performance of the stocks of 400 corporations that have passed multiple social screens. Coupled with the demand for increasing corporate social re sponsibility, there has been a move away from the traditional view that managers make decisions that are in their common shareholders' best interests to a stakeholder concept where managers make decisions for and serve a much broader group of claim-holders than just share holders. Joichi Aoi, Chairman of the Board at Toshiba Corporation, has argued that today's managers need to broaden their perspective beyond the traditional shareholder thinking:

Bank CEO Pay-Performance Relations and the Effects of Deregulation

The authors test the deregulation hypothesis that posits that bank CEO compensation became more sensitive to performance as bank management became less regulated. They observe a significant increase in pay-performance sensitivities from their 1976-81 regulation subsample to their 1982-88 deregulation subsample. These increases in pay sensitivities after deregulation are observed for salary and bonus, stock options, and common stock holdings. The authors observe increases in the pay-performance relation associated with high-capitalization-ratio banks, consistent with providing incentives for wealth creation while even larger increases in pay-performance sensitivity for lower capitalization-ratio banks suggest an Federal Deposit Insurance Corporation moral hazard problem. Copyright 1995 by University of Chicago Press.

Conversion-forcing security calls: Wealth transfers revisited

We reexamine evidence of wealth effects on various classes of security holders due to calls of convertible bonds and preferred stocks. Significant average devaluations of common equity documented in previous research are found in our sample and, unlike earlier studies, evidence is reported of a significant wealth transfer from common stockholders to senior security holders upon announcement of calls of convertible bonds. Thus, for convertible bond calls, some of the adverse price reaction for common stocks is gained by senior claimants.

The impact of calls of preferred stock on common shareholders' wealth

This paper examines the behavior of common stock prices around the announcement dates of calls of straight and convertible preferred stock. Our results indicate that calls of in-the-money convertibles result in a decrease in stock price. On the other hand, we find that calls of out-of-the-money convertibles are associated with stock price increases. In addition, our results indicate that the negative price impact of in-the-money calls is related to the reduction in cash dividend payout induced by the conversion of preferred stock to common stock, and not related to whether the call is underwritten or not, and the “moneyness” of the convertible preferred. Finally, we find that calls of straight preferred that are financed with debt result in an increase in stock price, while all other straight preferred calls have no impact on stock price.

Wealth transfers and the initial pricing of PERCS

The purpose of this paper is to examine the initial pricing of a form of convertible preferred stock, PERCS (preferred equity redemption cumulative stock). The analysis shows that investors may pay more for the PERCS than the value of the individual components of the financially engineered security. The empirical results suggest that PERCS may be a cheaper way for firms to issue equity causing wealth transfers from holders of PERCS to common stock shareholders.

Stakeholder Losses in Corporate Restructuring: Evidence from Four Cases in the North American Steel Industry

This paper presents an empirical investigation of costs associated with four major restructurings in the North American steel industry over the past decade. In contrast to many previous studies which concentrated mainly on the impact of restructuring on shareholders and bondholders, this study considers the losses suffered by all stakeholders of the four sample firms. The stakeholders examined include labor, suppliers, unsecured creditors, and government agencies in addition to the debtholders and preferred and common shareholders. The study also examines the administrative and legal costs associated with restructurings. The aim of the paper is to evaluate the wealth losses suffered by all stakeholders and to conduct a longitudinal analysis of these restructurings in order to evaluate the relative magnitude of these wealth losses. The combined losses suffered by all stakeholders in the four restructurings analyzed in this paper are estimated at approximately $7 billion.

Corporate Restructurings Involving Real Estate Assets: Some Earnings and Risk Signal Implications

Changes in common stockholder wealth when companies announce purchases and sales of real estate assets may result from changing investor perceptions about the risk, timing and/or amount of future c...

THE IMPACT OF SALE‐LEASEBACKS TRANSACTIONS ON BONDHOLDER AND SHAREHOLDER WEALTH

Prior research has shown that a sale and leaseback transaction (SLBT) results in positive average abnormal returns to the lessee's common stockholders. Researchers have conjectured that this could be due to SLBT tax benefits or due to a wealth transfer from bondholders (since after the SLBT it is possible that fewer assets remain as collateral). This study shows that bondholders do not lose in SLBT's and confirms previous results showing that stockholders gain from sale leaseback transactions. The results are consistent with the position that bondholders write provisions to protect their rights to the underlying assets, resulting in no wealth transfer from bondholders to stockholders when the firm sells off assets and leases them back.