Why do managers avoid EPS dilution? Evidence from debt-equity choice
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Publication Details
Output type: Journal article
Author list: Huang R., Marquardt C., Zhang B.
Publisher: Springer
Publication year: 2013
Journal: Review of Accounting Studies (1380-6653)
Volume number: 19
Issue number: 2
Start page: 1
End page: 36
Number of pages: 36
ISSN: 1380-6653
eISSN: 1573-7136
URL: http://api.elsevier.com/content/abstract/scopus_id:84889074638
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Open access status: closed
Abstract
Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt-equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms' speed of adjustment to target leverage ratios and firms' debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers' aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making. © 2013 Springer Science+Business Media New York.
Keywords
Agency conflicts, Debt-equity financing, Dilution, Earnings per share (EPS), Executive compensation
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