The impact of financial incentives on firm behavior

Thesis (Ph. D.)--Massachusetts Institute of Technology, Dept. of Economics, 2006.Includes bibliographical references.This dissertation analyzes the impact of various financial incentives on firm behavior. The first two chapters examine product-market and input-market effects of a firm's capital structure and the incentives they create. The third chapter analyzes how incentives from the tort system affect physician location decisions. Chapter 1 examines the impact of union bargaining on capital structure determination. If a firm maintains a high level of liquidity, workers may be encouraged to raise wage demands. In the presence of external finance constraints, a firm has an incentive to use the cash flow demands of debt service payments to improve its bargaining position. Using both cross-sectional estimates of firm-level collective bargaining coverage and state changes in labor law to identify changes in union bargaining power, I show that firms indeed appear to use financial leverage strategically to influence collective bargaining negotiations. These estimates suggest that strategic incentives from union bargaining have a substantial impact on financing decisions. A firm's financial structure can also impact investments in marketing and operations management. Chapter 2 examines how capital structure affects a firm's provision of product availability - an important dimension of product quality in the retail sector.(cont.) Using U.S. consumer price index microdata to measure the prevalence of out-of-stocks, I find that supermarket leveraged buyouts, which reduce liquidity, increase out-of-stocks by 10 percent. These findings suggest it is important for firms to consider these sorts of real effects on their operations when setting financial policy. Chapter 3 examines financial incentives created by medical malpractice liability. If patients bear the full incidence of cost changes and market demand is inelastic, then marginal changes in malpractice liability will not affect physicians' net income or location decisions. Using county-level, specialty-specific data on physician location from 1970 to 2000, I find that damage caps do not affect physician supply for the average resident of states adopting reforms. On the other hand, caps appear to increase the supply of specialist physicians in the most rural areas by 10 to 12 percent. This is likely because rural doctors face greater uninsured litigation costs and a more elastic demand for medical services.by David Abraham Matsa.Ph.D

Common Errors: How to (and Not to) Control for Unobserved Heterogeneity

Controlling for unobserved heterogeneity (or “common errors”), such as industry-specific shocks, is a fundamental challenge in empirical research.This paper discusses the limitations of two approaches widely used in corporate finance and asset pricing research: demeaning the dependent variable with respect to the group (e.g., “industry-adjusting”) and adding the mean of the group\u27s dependent variable as a control. We show that these methods produce inconsistent estimates and can distort inference. In contrast, the fixed effects estimator is consistent and should be used instead. We also explain how to estimate the fixed effects model when traditional methods are computationally infeasible

Growing Out of Trouble? Corporate Responses to Liability Risk

This article analyzes corporate responses to the liability risk arising from workers\u27 exposure to newly identified carcinogens. We find that firms, especially those with weak balance sheets, tend to respond to such risks by acquiring large, unrelated businesses with relatively high operating cash flows. The diversifying growth appears to be primarily motivated by managers\u27 personal exposure to their firms\u27 risk in that the growth has negative announcement returns and is related to firms\u27 external governance, managerial stockholdings, and institutional ownership. The results suggest that corporate governance is particularly important when firms are exposed to the risk of large, adverse shocks

Labor Unemployment Risk and Corporate Financing Decisions

This paper examines the impact of labor unemployment risk on corporate financing decisions. Theory suggests that firms choose conservative financial policies partly as a means of mitigating worker exposure to unemployment risk. Using changes in state unemployment insurance benefit laws as a source of variation in the costs borne by workers during layoff spells, we explore the connection between unemployment risk and the corporate financing decisions of public firms in the United States. We find that increases in legally mandated unemployment benefits lead to increases in corporate leverage. The impact of reduced unemployment risk on financial policy is especially strong for firms that have greater layoff separation rates, labor intensity, and financing constraints. The estimated premium required to compensate workers for unemployment risk due to financial distress is about 57 basis points of firm value for a BBB-rated firm. These findings suggest that labor market frictions have a significant impact on corporate financing decisions

Labor unemployment risk and corporate financing decisions

This paper presents evidence that firms choose conservative financial policies partly to mitigate workers' exposure to unemployment risk. We exploit changes in state unemployment insurance laws as a source of variation in the costs borne by workers during layoff spells. We find that higher unemployment benefits lead to increased corporate leverage, particularly for labor-intensive and financially constrained firms. We estimate the ex ante, indirect costs of financial distress due to unemployment risk to be about 60 basis points of firm value for a typical BBB-rated firm. The findings suggest that labor market frictions have a significant impact on corporate financing decisions

CEO Compensation and Corporate Risk: Evidence From a Natural Experiment

This paper examines the two-way relationship between managerial compensation and corporate risk by exploiting an unanticipated change in firms\u27 business risks. The natural experiment provides an opportunity to examine two classic questions related to incentives and risk—how boards adjust incentives in response to firms\u27 risk and how these incentives affect managers\u27 risk-taking. We find that, after left-tail risk increases, boards reduce managers\u27 exposure to stock price movements and that less convexity from options-based pay leads to greater risk-reducing activities. Specifically, managers with less convex payoffs tend to cut leverage and R&D, stockpile cash, and engage in more diversifying acquisitions

Protocol for the Arterial Revascularisation Trial (ART). A randomised trial to compare survival following bilateral versus single internal mammary grafting in coronary revascularisation [ISRCTN46552265]

BACKGROUND: Standard coronary artery bypass graft surgery uses a single internal mammary artery and supplemental vein or radial artery grafts. Several observational studies have suggested a survival benefit with two internal mammary artery grafts compared to a single internal mammary artery graft, but this has not been tested in a randomised trial. The Arterial Revascularisation Trial is a Medical Research Council and British Heart Foundation funded, multi-centre international trial comparing single internal mammary artery grafting versus bilateral internal mammary artery grafting. METHODS/DESIGN: Twenty centres in the UK, Australia, Poland and Brazil are planning to randomise 3000 coronary artery bypass graft surgery patients to single or bilateral internal mammary artery grafting. Supplemental grafts may be either saphenous vein or radial artery. Coronary artery bypass grafting can be performed as an on-pump or off-pump procedure. The primary outcome is survival at 10 years and secondary end-points include clinical events, quality of life and cost effectiveness. The effect of age, left ventricular function, diabetes, number of grafts, vein grafts and off-pump surgery are pre-specified subgroups. DISCUSSION: The Arterial Revascularisation Trial is one of the first randomised trials to evaluate the effects on survival and other clinical outcomes of single internal mammary artery grafting versus bilateral internal mammary artery grafting, and will help to establish the best approach for patients requiring coronary artery bypass graft surgery