{"title":"The income bond puzzle","authors":"John J. McConnell, Gary G. Schlarbaum","doi":"10.1111/jacf.12544","DOIUrl":"10.1111/jacf.12544","url":null,"abstract":"<p>The 1980's promise to be an exciting decade for American capital markets. Recent descriptions of our financial environment have featured such problems as capital shortages, inflation at unprecedented rates, and more than the usual amount of volatility and uncertainty in the credit markets. It is a time of financial innovation; deep discount bonds, GNMA pass-through securities, and financial futures and options are only a few of the new financing instruments that are now being developed and introduced at an unusually rapid pace. It is also a time of financial crisis, in which several very large publicly-held firms have failed or approached the brink of failure.</p><p>In such an environment, it is important for the practicing financial manager to be familiar with the full array of financial instruments at his disposal. Our intention in this article is to draw attention once again to a frequently advocated, but infrequently used class of corporate security: the income bond.</p><p>Before investigating this income bond “puzzle,” let's first review the features of the income bond.</p><p>Income bonds are hybrid instruments which combine the features of straight debt securities and preferred stock. Like straight debt, income bonds are a contractual obligation of the issuer; they give the holder a claim on the company's earnings that ranks ahead of all equities, preferred and common. At the same time, however, they represent a contingent claim: interest is payable only if earned. And, because the income bond is in fact a debt instrument, the interest payments are tax deductible to the corporate issuer.</p><p>That the payment of coupon interest depends on the level of the issuer's reported accounting earnings, is, of course, the most important characteristic distinguishing income bonds from other debt instruments. If sufficient accounting earnings are available after the deduction of operating expenses, allowable fixed asset depreciation, and interest payments with a prior claim on income, then the interest due on the income bonds <i>must</i> be paid. But if reported earnings (after deduction of the various allowed expenses) are not sufficient to cover contingent interest payments, the corporation may pass the payment with no change in the ownership structure of the company.</p><p>Thus, when a contingent interest payment is omitted, the bond technically is not in default, and bondholders obtain no additional control over the company (except for the possible future claim to accumulated interest). In contrast, when an interest payment is omitted on a fixed-interest bond, it is considered to be in default, and the bondholders may force the company into bankruptcy.</p><p>It is also worth noting, however, that income bonds can take on many of the characteristics of more conventional forms of debt. They may be callable, convertible into common stock, or subordinated to other classes of debt securities. They may contain sinking fund provisions. Also, and perha","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"35 1","pages":"8-15"},"PeriodicalIF":0.9,"publicationDate":"2023-04-24","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"https://onlinelibrary.wiley.com/doi/epdf/10.1111/jacf.12544","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"44834071","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"OA","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"Do investment banks have incentives to help clients make value-creating acquisitions?","authors":"John J. McConnell, Valeriy Sibilkov","doi":"10.1111/jacf.12546","DOIUrl":"https://doi.org/10.1111/jacf.12546","url":null,"abstract":"<p>To many observers, it has long seemed evident that there is a potential conflict between the interests of the investment bankers that do M&A advisory work and the shareholders of the acquiring companies they advise. The potential conflict arises because advisory contracts are structured to reward the bankers for “getting deals done,” with much less reward for deals that do not get done. In other words, contracts are structured so that the bankers generate the lion's share of their fees from those transactions in which their corporate clients end up acquiring the companies they target—but negligible amounts for advisory work that does not lead to a transaction.</p><p>Unfortunately for shareholders of the acquiring corporation, overpaying for an acquisition is a fairly surefire way of ensuring that an acquisition takes place. Indeed, there is a body of evidence from the 1970s and 1980s that suggests that acquirers, on average, were willing to do just that.1 In the many M&A deals that got done during those decades, the shareholders of the companies acquired usually seemed to fare significantly better, on average, than the shareholders of the companies doing the acquiring.2</p><p>And yet, as that columnist went on to point out, Wasserstein's career on Wall Street did not seem to have suffered from his reputed indifference to the shareholders of his corporate clients. Early scholarly evidence on that question tended to support the notion that banks and bankers were not penalized for facilitating overpriced deals.</p><p>In a study that was recently published in the <i>Review of Financial Studies</i>, we re-examined the evidence on the questions: Do bankers pay any penalty for advising on value-destroying acquisitions? Or, conversely, is there any reward to bankers for creating value for their acquisition-minded clients? These questions would seem to be important given that, in the United States alone, corporate acquirers paid investment banks over $20 billion in advisory fees to facilitate their acquisitions during the decade 2002–2011.5</p><p>One of the first studies of advisory contracts in mergers and acquisitions was conducted by Robyn McLaughlin, while a finance professor at Boston College, and its findings were published in an article in the <i>Journal of Financial Economics</i> in 1990. McLaughlin studied advisory contracts in corporate tender offers from 1978 to 1985. He observed that the compensation advisors are paid—the advisory fees—were not contingent on whether the transaction creates value for the client, which is the acquirer. In the typical contract, more than 80% of the advisory fee was paid only if the acquisition was completed. He noted that such contracts appeared to create a severe conflict of interest in which the advisor had an incentive to complete the acquisition regardless of the valuation consequences for the acquirers’ shareholders.</p><p>When discussing his findings, McLaughlin went on to speculate that other me","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"35 1","pages":"91-102"},"PeriodicalIF":0.9,"publicationDate":"2023-04-24","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"https://onlinelibrary.wiley.com/doi/epdf/10.1111/jacf.12546","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"50153827","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"OA","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"Investor base, cost of capital, and new listings on the NYSE","authors":"Gregory B. Kadlec, John J. McConnell","doi":"10.1111/jacf.12538","DOIUrl":"https://doi.org/10.1111/jacf.12538","url":null,"abstract":"<p>The notion that investor base has an effect on share value has intuitive appeal and is strongly supported by “streetlore.” But standard finance theory, as represented by the familiar Capital Asset Pricing Model (CAPM) or its recent challenger, the Arbitrage Pricing Theory (APT), does not attribute any particular role to the size of investor base as a determinant of share values. Indeed, from the perspective of traditional finance theory, each of the corporate actions cited above is viewed as value neutral. Yet empirical research suggests that certain of these corporate practices are associated, at least on average, with an increase in share values. While various explanations have been offered for these increases in share value, the role of investor base has been largely unexplored.</p><p>In this article, we report the results of our recent study of 273 companies that during the 1980s decided to switch the trading locale of their shares from the over-the-counter (OTC) or NASDAQ market to the NYSE.1 We found that share prices increased by about 6%, on average, at the time the stocks became listed on the NYSE, and that the investor base of these firms increased by almost 20%. We also found that the average stock experienced a reduction in bid/ask spread of about 5% after listing. In an analysis of the relation among share prices, investor base, and bid/ask spread, we found that the stock price increase was significantly correlated with both the percentage increase in investor base and the reduction in bid/ask spread.</p><p>In short, our analysis supports the popular idea that an expanded shareholder base can increase a firm's stock price.</p><p>We are not, of course, the first to study the effect of an NYSE listing on share price. That honor appears to belong to a study published in the <i>Journal of Business</i> in 1937.2 Like most research on listings that came after it, this early study came to the conclusion that a new listing on the NYSE is associated with an increase in stock price.3 Financial theorists have tended to attribute this increase in value to the increase in “liquidity” that is said to accompany stocks that switch to the NYSE. Typical of this thinking is a 1986 study (involving one of the present authors)4 which argues that the differences in the market structure and means of transacting between the NYSE and the OTC market could lead to a lower cost of transacting and, therefore, greater liquidity. The greater liquidity, in turn, leads to a higher stock price.</p><p>We conducted our analysis on a sample of 273 NASDAQ stocks that became newly-listed on the NYSE during the period August 1980 through December 1989. This sample includes all stocks that listed over this period (except those that listed during October 1987) for which sufficient data were available to conduct the study. The sample covers a wide range of industries, with firms representing 50 of the 83 possible two-digit Standard Industrial Classification (SIC) codes. Of","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"35 1","pages":"27-30"},"PeriodicalIF":0.9,"publicationDate":"2023-04-24","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"https://onlinelibrary.wiley.com/doi/epdf/10.1111/jacf.12538","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"50153833","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"OA","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"The origin of LYONs: A case study in financial innovation","authors":"John J. McConnell, Eduardo S. Schwartz","doi":"10.1111/jacf.12537","DOIUrl":"https://doi.org/10.1111/jacf.12537","url":null,"abstract":"<p>Viewed at a distance and with scholarly detachment, financial innovation is a simple process. Some kind of “shock”—say, a sudden increase in interest rates volatility or a significant regulatory change – is introduced into the economic system. The shock alters the preferences either investors or issuers in such a way that there then exists no financial instrument capable of satisfying a newly-created demand. Observing the unsatisfied demand, an entrepreneur moves quickly to seize the opportunity by creating a new financial instrument. In the process, the entrepreneur reaps an economic reward for his efforts, investors and issuers are better served, and the entire economic system is improved.</p><p>On closer inspection, however, the actual process of financial innovation turns out, like most other human endeavors, to be a lot less tidy than economists’ models would have it. In this article, we provide an “up-close” view of the origin and evolution of one financial instrument—the Liquid Yield Option Note (LYON).</p><p>The LYON is a highly successful financial product introduced by Merrill Lynch in 1985. Between April 1985 and December 1991, Merrill Lynch served as the underwriter for 43 separate LYON issues, which together raised a total of $11.7 billion for corporate clients. LYON issuers include such well-known firms as American Airlines, Eastman Kodak, Marriott Corporation, and Motorola. In 1989, other underwriters entered the market and have since brought an additional 13 LYON-like issues to market. In the words of a recent <i>Wall Street Journal</i> article, the LYON is “one of Wall Street's hottest and most lucrative corporate finance products.”1</p><p>As academics examining a new security, we begin by posing the questions: What does the LYON provide that was not available previously? Does the LYON really increase the welfare of investors and issuers, or is it simply a “neutral mutation”—that is, a now accepted practice that serves no enduring economic purpose, but is sufficiently harmless to avoid being extinguished by competitive forces.2</p><p>In the spirit of full disclosure, however, we must admit that we are not entirely disinterested observers. Our association with the LYON is longstanding. When the early LYON issues were being brought to market in April 1985, questions arose about LYON pricing. We were hired by Merrill Lynch to develop a model for analyzing and pricing this new financial instrument. A by-product of this assignment was the opportunity to learn about the train of events that led to the creation of the LYON, and we have since followed the evolution of this market with interest. In the pages that follow, we relate what we have observed, thought, and contributed during the development of this new security.</p><p>The LYON is a complex security. It is <i>a zero coupon, convertible, callable, and puttable</i> bond. None of these four features is new, it is only their combination that makes the LYON an innovation. These gen","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"35 1","pages":"20-26"},"PeriodicalIF":0.9,"publicationDate":"2023-04-24","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"https://onlinelibrary.wiley.com/doi/epdf/10.1111/jacf.12537","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"50153832","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"OA","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"A Message from the Editor","authors":"Don Chew","doi":"10.1111/jacf.12548","DOIUrl":"https://doi.org/10.1111/jacf.12548","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"35 1","pages":"2-3"},"PeriodicalIF":0.9,"publicationDate":"2023-04-23","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"50141203","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"Is it time to rethink the Federal Reserve?","authors":"","doi":"10.1111/jacf.12532","DOIUrl":"10.1111/jacf.12532","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"34 4","pages":"85-100"},"PeriodicalIF":0.9,"publicationDate":"2023-03-12","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"46167403","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Jeffrey Greene, Greg Milano, Alex Curatolo, Michael Chew
{"title":"Driving outperformance: The power and potential of economic profit","authors":"Jeffrey Greene, Greg Milano, Alex Curatolo, Michael Chew","doi":"10.1111/jacf.12531","DOIUrl":"10.1111/jacf.12531","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"34 4","pages":"78-84"},"PeriodicalIF":0.9,"publicationDate":"2023-02-28","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"44846127","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
John R. Graham, Jillian A. Grennan, Campbell R. Harvey, Shivaram Rajgopal
{"title":"Corporate culture: The interview evidence","authors":"John R. Graham, Jillian A. Grennan, Campbell R. Harvey, Shivaram Rajgopal","doi":"10.1111/jacf.12528","DOIUrl":"https://doi.org/10.1111/jacf.12528","url":null,"abstract":"<p>Culture is given credit for some of the greatest business successes and blamed for some of the biggest failures. Policymakers often point to dysfunctional corporate culture in banking as a first-order contributor to the recent financial crisis.1 Several books identify culture as a key driver of Google's success.2</p><p>We try to answer these questions in multiple ways. First, we surveyed 1348 chief executives and financial officers (CEOs and CFOs, referred to interchangeably as executives or managers) across a wide range of North American public and private firms. The details underlying the survey evidence and an econometric investigation into the effects of culture on business outcomes are reported in an accompanying paper5 by the same four authors that supplement this paper; referred to henceforth as GGHR. Second, the survey contained several open-ended questions. We analyze the text of these questions to enhance our understanding of the survey respondents' views of the corporate culture. Third, we conducted in-depth interviews with business executives representing over 20% of the US equity market capitalization. The purpose of this paper is to discuss the interview evidence and the open-ended responses from the survey. We summarize the survey statistics to provide context for the interviews and open-ended responses.</p><p>Survey evidence offers a number of insights into corporate culture. Briefly, the survey shows that managers are largely united in believing that corporate culture is one of the most important forces behind value creation and the ultimate success or failure of a firm. The majority of executives consider corporate culture to be a top three value driver at their companies. Almost every officer believes that improving their corporate culture would increase their firm's value. The current CEO is seen as the most influential person responsible for setting the firm's current culture.</p><p>The interviews offer insight into how other firm policies and practices may reinforce or work against the effectiveness of the culture. Boards affect culture not via active management but primarily via CEO choice. The finance function may influence the culture, especially when it serves an internal governance role by acting as steward of integrity. Incentive compensation and hiring, firing, and promotion decisions also may modify the effectiveness of a firm's culture. Some schemes reinforce the culture by rewarding employees for living the values of the culture while other schemes that are not well aligned with the culture lead employees to ignore the cultural values.</p><p>Additional survey evidence reveals what decisions and actions are influenced by corporate culture. Managers believe that corporate culture has a substantial effect on the creativity at the firm, the productivity of employees, and hence, on firm value and on profitability. Cultural fit is seen as so important in an M&A deal that most managers would walk away from acquirin","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"34 4","pages":"22-41"},"PeriodicalIF":0.9,"publicationDate":"2023-02-23","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"https://onlinelibrary.wiley.com/doi/epdf/10.1111/jacf.12528","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"137976271","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"OA","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"Rising intangibles, negative cash flows, and corporate funding practices","authors":"David J. Denis, Stephen B. McKeon","doi":"10.1111/jacf.12529","DOIUrl":"10.1111/jacf.12529","url":null,"abstract":"","PeriodicalId":46789,"journal":{"name":"Journal of Applied Corporate Finance","volume":"34 4","pages":"42-50"},"PeriodicalIF":0.9,"publicationDate":"2023-02-22","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"45873282","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
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