Seminar in Financial Management's Blog

–          There is no significant relationship between board composition and shareholders’ wealth

–          There is no significant relationship between directors’ remuneration and shareholders’ wealth

–       Efficiency, effective, and productivity

–       Governance’s reliability

–          board composition

–          directors’ remuneration

–          ROI and EPS.

• Questionnaire is given to check Test and Retest reliability
• Using SPSS software to do statistical analysis.

Largest percentage of responses, both during test and retest, are in the “agree” category, those who are agree with the statement given (55.2% during test and 50.4% during retest.)

Conclusion

–          The majority of responses are toward agreement (65.2% & 62.0%) with the statement which show that majority agreed with the identified roles of social audit.

–          A large number of responses are also in the undecided / can’t say category (21.7%&21.6%).

The benefit or role areas are:

–          Stakeholder accepted that social audit helps the government in monitoring, accounting for and reporting the activities/action.

–          The exercise of social audit improves social, ethical and environmental performance.

–          Public is concerned and confident that social audit contributes towards achievements of efficacy and effectiveness of the administration.

–          The important finding was that is creates confidence on governmental action in community.

–          Make administration more transparent and accountable.

–          Provide verifiable data to substantiate claims on social performance.

–          Enhance inclusion, patership and participation.

–          Collectively, social audit is a tool for social accountability in good governance.

–   Descriptive Statistics of Board Structure

The results indicate that the number of directors in a board for all companies on the Second Board is similar, irrespective of the year (mean score: 7.15 in 2002; 7.07 in 2003; 7.13 in 2004).

–  Descriptive Statistics of Financial Performance

The results indicate that most companies in the Second Board failed to realize an adequate return on equity invested by shareholders. The results indicate that most companies in the Second Board have a lower corporate value, an indication that the companies may not be able to sell off their shares easily

–  The Effect of Board Size and Shareholders’ Wealth

Hypothesis 1 that states no significant relationship between board size and shareholders wealth as measured by ROI and EPS is rejected.

–  The Effect of Board Composition on Shareholders’ Wealth

Hypothesis 2 that states no significant relationship between board composition and shareholders wealth as measured by ROI and EPS may be rejected.

–  The Effect of Directors’ Remuneration on Shareholders’ Wealth

Hypothesis 3 that states no significant relationship between directors’ remuneration and shareholders wealth as measured by ROI and EPS is accepted.

Conclusion

–  The results in this study are consistent to previous studies that show positive relationship between board size on company’s performance

–  The results showing marginally negative relationship indicate that a higher proportion of executive directors may be crucial in ensuring that all the assets are being utilized efficiently.

–  This study implicate that a company’s performance does not depend on how much the directors received their compensation but more on the number of directors in a board or the proportion of executive and non-executive directors in a board.

–   The evidence in this study points to the fact there is a need to monitor and effectively organise the structure of a board to ensure good corporate governance practices is upheld.

• Ownership structure affects investment
• Foreign firm were less credit-constrained than domestic firm.
• Firm with high foreign ownership can raise fund at low costs
• Cash flow sensitivity of investment to be lower in foreign owned firm than in domestically owned firm

_– I_t

–          Q_t
TA_t

_– B_t

_– E_t

_– CF_t

_– High_i

_– Low_i

_– Before_t

_– After_t

–          Semi-formal financial sector

–          Informal financial sector

–          Bank

–          Co-operatives

–          Microfinance institution

–          ROSCAs

–          ASCAs

–          The availability of internal funds does affect investment levels.

–          Cash flow has significant impact on the investment of firm with low foreign ownership.

–          The opening of stock market is surely one of the factors in the mitigation of financial constraint although it may not be the only reason.

–          Liquidity constraints are reduced mainly in firms with low foreign ownership.

–          If the value of the firm is directly related to financial constraint that the firm faces, the effect of cash floe on investment may also have non-linear relationship with the level of foreign ownership.

–          Foreign ownership seems to have a linear relationship to financial constraints.

Conclusion:

Foreign ownership improves a firm’s accessibility to external finance. The finding simply suggest that foreign ownership plays role in reducing financial constraints on firm, and thus improves accessibility of external financing investment. In addition asymmetry can also be a potential benefit of open financial market.

• Employment or main income source is the factor that most influence on access and exclusion in both countries.
• Government employees are nine times more likely to use formal services and seven times less likely to be completely excluded from financial services compared to the base category. They are half as likely to only use semi-formal services and four times less likely to only use informal services.
• Age also has strong effects in both countries. In Kenya the effects are strong and consistent, the older group are much less likely to be excluded than 18-24 year old. In Uganda, those in 25-34 and 35-44 age groups are significantly more likely to be formally included than the 18-24 year category, but age categories over 45 are not.
• In Uganda being rural or urban had no significant effects, while Kenya-perhaps contrary to expectation-being rural significantly reduced the like hood of being excluded overall and this matched by marginally significant increase in the like hood of inclusion via the semi-formal sector.
• In Kenya inclusion via the formal sector reduces that exclusion. In Uganda the region was weakly significant in its impact on inclusion via formal sector.
• The impact of education is strong in both countries and presents a clear pattern
• In Kenya, being a woman significantly lowers the likelihood of exclusion from financial services overall. In Uganda, women were significantly less likely to be included via the formal sector than men

Conclusions:

• It has found overall that employment, age, education, gender and geography are key factors but that in these countries access to formal services was not as strongly influenced by geography as other studies have concluded.
• Underlying social institutions – of which age, gender, educational attainment and so on are indicators – are clearly important to understanding patterns of access and exclusion. This suggests, at the policy level, that widening access requires that these causes of exclusion are adequately addressed and that emphasis on lowering transactions costs is not likely to be sufficient.

structure and dividend policies

in an emerging market

–  Asymmetric information, managers are willing to use leverage and or dividends as a means of providing a positive signal to capital markets.

–  The Agency model uses dividend policy to better align the interests of shareholders and corporate managers

–  Many previous studies have found conflicting result, even when controlling for the possibility of simultaneity.

– Dividend policy (dividend decision and ratio) of top Egyptian listed companies is significantly associated with ownership structure.

–          Dividends (DIV)

–          Firm’s ownership (OWN)

–          Firm’s cash flow (CF)

–          Firm liquidity (CR)

–          Profitability (PRO)

–          Firm’s size (SIZE)

– dividend decisions (DIVDECISION)

– dividend paid (DIVRATIO)

Board of directors’ composition

– board size (BOARDSIZE)

–  board independence (INDEPENDENCE)

–  dual role (DUALROLE)

Ownership structure

–       managerial ownership ratio

–       blockholder ownership ratio

–       institutional ownership ratio

–        free float ratio

– The Pearson’s correlation matrix

See some striking differences in sign, magnitude, and significance particularly with regard to the ownership, dividend, and profitability variable.

The dividend equation results

The Own and LEV coefficient estimates are both significantly positive, implying that not only are debt and dividend policy complementary, but also the higher ownership level leads to higher dividend, possibly to prevent entrenched managers from acting in a manner inconsistent with stockholder.

The ownership equation results

– The CF and CR variables have negative and significant coefficient estimates implying that liquidity is not significant determinant of managerial ownership.

–  SIZE is not significant

–   CF statically significant

Conclusions:

–  The higher levels of ownership and dividends negatively affect leverage.

– Ownership and leverage both positively impact dividend.

–  Leverage negatively associated with ownership, while dividend positively impact ownership.

-The Pearson’s correlation matrix (Table II) shows that the degree of correlation between the independent variables is either low or moderate, which suggests the absence of multicollinearity between independent variables.

– Table III, Companies with higher return on equity and higher institutional non-governmental ownership were more likely to take a decision of distributing dividends.

– Table IV, dividend payout ratio is also positively associated with institutional non-governmental ownership and firm performance (return on equity)

Conclusions:

– Strong support was found for the signalling model, from the significant association between dividend and firm performance

–  Partial support was obtained for agency theory, from the significant positive association between dividend and institutional ownership.

– In the emerging market of Egypt, top performing Egyptian listed companies with higher block institutional ownership, which implies lower agency costs  paid higher dividends to attract capital during the transitional period of Egypt.

– Signaling theory, the information asymmetry pertains to current earnings and the level of investment.

– The signaling predicts that the higher the analyst following, the lower the dividend.

Conventional dividend yield (DIVYLD)

Independent variable

–   Insider ownership

–   Analyst following

–   Growth opportunities (MTOB)

–   Cash flow (CFTOB)

DY (Dividend Yield)

Other variable

–  BETA

–  REV 5

–  IBES5

–  INSIDE

– CSLN

–  PropCas

Dividend policy and insider ownership, indicate that dividends are related to the insider ownership variable. This finding do not support for the monitoring role of dividends in reducing agency costs of equity.

Dividend policy and equity issues, the amount paid as dividends is negatively related to the amount raised through the equity offering.

Dividend Policy and Firm Size, find positive relationship between dividend yield and size. Firm size may serve as a proxy for asymmetric information where larger firms have less asymmetric information.

Dividend Policy, Asymmetric Information and Issue Cost, indicates that after controlling for firm size, issue costs are negatively related to analyst following.

Conclusion

– Dividends are positively related to both analyst following and cash flow, but negatively related to growth opportunities.

–  The positive relation between dividends and analyst following is consistent with pecking order theory and inconsistent with the signaling theory.

– Dividends are unrelated to the insider ownership variable when the level of asymmetric information is explicitly controlled.

– The relation among dividends, asymmetric information, and issue costs also rules out a size-based explanation of dividend policy and established that analyst following has a separate effect on dividend policy apart from firm size.

–  The insurance organization on average have lower IndCGQ score and higher inside ownership.

–  From table 1 show that the overall DY of the insurance organizations is lower than in previous research, but there is wider dispersion of stock among market participant.

– IndCGQ is not significant, IBES5, REV5 and CSLN are highly significant

– For highly regulated firms, the industry CGQ variable is significant and therefore cannot substitute as a bonding mechanism in lieu of a DY.

Conclusion:

– Inconsistent with the theory that strong corporate governance supplants the need to subject the firm to the external monitoring of capital market forced due to dividend distribution.

– Strong corporate governance appears to be unrelated to dividend payout in the insurance industry.

–  The more highly regulated property and casualty insurers do appear to pay out more in dividends.

–  The signaling theory based on asymmetric information problems.

–  The agency theory, based on asymmetric information problem that is principal-agent conflict.

–  Pecking order theory, use their retain earning, and then move to debt when their internal fund run out.

–  Pecking order theory, use their retain earning, and then move to debt when their internal fund run out.

1. The effective tax rate is expected to be positively related to the debt level.
2. Non-debt tax shields should be negatively related to firm debt.
3. Default risk should be negatively related to the firm’s debt ratio.
4. Companies with greater growth opportunities will have a smaller debt ratio.
5. There should be a positive relationship between debt ratio and firm profitability.
6. The size of the company should be positively related to the level of debt.
7. SMEs face significant transaction cost which keep them far from their target.

Based on pecking order

1. The financing deficit of SMEs should be positively related to the change in the level of debt.
2. Firm debt should be negatively related to the volume of firm cash flow.
3. Firm with few investment opportunities and high cash flow should have a low level of debt, while firms with strong growth prospects and reduced cash flow should have high debt ratio.
4. The age of the company should be negatively related to its level of debt.

–          Book leverage

–          Market leverage

Explanatory variable:

–          Non-debt tax shield (NDTS)

–          Tangibility

–          Profitability

–          Business Risk

–          Growth opportunities

–          Growth

–          Size

–          Agency variables

–          Effective tax rate (ETR)

–          Non-debt tax shield (NDTS)

–          Default risk (DR)

–          Growth opportunities (GO)

–          Profitability (ROA)

–          Size

–          Cash flow (CF)

–          CFGO

–          AGE

–     There has been significant decrease in mean debt-equity ratio in post liberalization period across the group and industries.

–     Except growth rate and size all other explanatory variables have significant correlation with leverage during pre-liberalization period whereas all the explanatory variables are significantly correlated with leverage during post-liberalization period.

–     The estimated coefficient of non-debt tax shield, cash operating profit, market-to book value ratio are consistently significant and have predicted sign across the equations.

–     Foreign investors are not adopting high leverage to discipline management.

Conclusion:

Measure of traditional factors that hypothesized to affect financing decision, namely profitability, tangibility, taxes and growth are all significant.

–       Spanish SMEs seem to find the cost of an unbalanced position less of a burden than the cost of adjusting. Hypothesis 7: accepted.

–       Current Spanish tax regulation does not provide relevant advantages to SMEs. Hypothesis 2:accepted but Hypothesis 1: is not

–       SMEs also prone to having large growth prospects and high debt ratios, thus making them very sensitive to Myers’ underinvestment problem. Hypothesis 4: accepted.

–       Firm size and leverage are found to be positively connected. Hypothesis 6: accepted.

–       All Hypothesis 9, 10,11 are found to be overwhelmingly confirmed. As expected, cash flow is negatively related to firm leverage; so the SMEs that generate the most internal resources are the least levered. The result consistent with pecking theory prediction.

–       A positive and significant relationship between the interactive variable CFGO and firm leverage is obtained. Hypothesis 10 is fulfilling.

–       Older SMEs may have generated sufficient internal resources to not depend as much on debt as younger SMEs, whose dependence on external resources will be greater.

Conclusion:

–       Regarding the trade-off theory, results clearly indicate that SMEs face high transaction costs which are probably derived from typical agency problems and financial restriction in capital markets.

–       Empirical evidence confirms that internal resources represent the main source of financing for SMEs.

–       Empirical evidence prove that NDTS, growth opportunities and internal resource play an important role in the decision making process.

–       SME and large firms display significantly distinct financial behavior, thus confirming the presumable financial restriction of SMEs.

-Mathematics is yes indeed a tool, but economics can only then be the master if the tool is used properly and the result are interpreted correctly.

1. The stronger the tie between the referee and the venture-capitalist, the stronger the referral.
2. The stronger the tie between the referee and the entrepreneur, the stronger the referral.
3. The venture capitalist’s trust in the referee is associated positively with investment decision.
4. The impact of referee-venture capitalist tie on referral will be greater in China than in Russia.
5. The impact of referee-entrepreneur tie on referral will be greater in China than in Russia.
6. The impact of venture capitalist’s trust in the referee on investment decisions will be greater in China than in Russia.

-Referee-venture capitalist tie

– Referee-entrepreneur tie

-Venture capitalist’s trust in the referee

–Dependent variables

Investment selection

– Control variables

– VC firm age

– The entrepreneurial team scale

–          IRR

Using several data sources, conducted structured telephone interview (firm decided to invest based on third parties and the opposite).

Sample: retrospective matched sample.

– By way of the NPV/IRR method, one can assess the conditional acceptability of one investment proposal solely, and mathematics does not pretend that it states anything meaningful with regard to the oder of two (or more) investment

Conclusions:

The NPV/IRR method neglects substantialism. The NPV e.q IRR fails in numerous cases in making sound capital budgeting decision. Because in fact that the NPV/IRR method meets only nominalism.

– 40% of private equity firms were fully or partially state-owned. The Chinese and Russian venture capitalists appeared to be experienced.

– Two samples (china-Russia) significantly differ from each other in several variables. For example: Third-party referrals are stronger in Russia. However, the referee-venture capitalist tie is stronger in China.

-The effect of dyadic ties on referral are significant and stable.

– VC firm size, IT industry, state ownership, entrepreneurial team, and growth potential have significant and positive effect on investment decisions. Hypothesis 3: supported

-Reveal that the effect of the predictor variable on the outcome variables are significant and positive, and the regression coefficients are the same in two countries. Hypothesis 4: not confirmed. Reveal that the effects of referee-entrepreneur tie are statiscally not significant in both Beijing and Moscow. Hypothesis 5: rejected.

-Reveals that trust of referee has no impact on investment decisions in China. In contrast other model shows that venture capitalist’s trust in the referee has significant positive effect on the investment decision of Russian venture capitalists. Hypothesis 6: not supported.

Conclusions:

-An empirical proof of the hitherto untested postulated of social network theory that transitivity is a function of tie strength and interpersonal trust.

-Triads are transitive or not depends on the referee-investor relationship, referee-entrepreneur ties and trust in the third party.

-The effects of dyadic ties and interpersonal trust on referral and investment decisions seems to be universal rather than country-or context specific, because industry factors have dominant effects on these outcomes variables.

-Interpersonal trust has greater effect on dependent variable in Russia.

–  Dichev 1998, Campbell, Hilscher, and Szilagyi 2006, Demers and Joos 2006, Robust across numerous specifications and controls for known risk factors, and is consistent with the inverse relation found between future returns and boarder measure of financial distress and bankruptcy risk in different contexts.

–  Fama and French 1992, 1998, hypothesize that the book-to-market ratio proxies for financial distress risk, and hence, should display a positive relation with expected and realized returns.

–  Wells Fargo and BARRA model have the form of APT (Arbitrage Pricing Theory) identify the major determinant of common stock prices and the weight the market place on these determinants.

–  Gruber and Elton 1995 assume that the market price will converge to the theoretical prices before the theoretical price itself change.

–          Unlevered pricing multiple

–          Financial leverage

–          Dependents variables

–         Risk factors

–       Market beta

–       Volatility of market price

–         Liquidity factors

–       Trading volume

–         Financial factors

–       P/E ratio

–       Dividend Paid

–       Past Growth in EPS

–       Future Growth in EPS

–       Growth in Sales

–       Growth in Devidend

–       Return on net Worth

–         Technical factors

–       Momentum of stocks

–       Excess return in last month

–       Excess return in last six month

–       Timelines

–       RSI

–       MACD

–       ROC

–       %K and %D

–         Economic factors

–       Interest rate fluctuation

–       Monson

–       Inflation

–       Groeth in GNP

–       Money supply to capital market

–       Forex rate

–       Quality of general budget

–         Industry specific factors

–       Growth of industry

–       Market share

–       Competition in the industry

–       Profit margin

–       Product life cycle

–          Company / specific factors

–          Quality and depth of management

–          Quality of audit report/auditors

–          Bonus issue

–          Normalized vs reported earnings

–          Market dominance

–          Strategic credibility

–          Others

–          Political factors

–          Dispersion of analysis forecast

–          Astrology

–          FII buying and selling

–          Advice of equity research agency

–          Independents Variables

–          Data source for company variables

–          Top management

–          Annual report

–          Employees

–          analysis

–          For industry variables

–          Primary source

–          Secondary

–          analysis

–          For economic variables

–          Primary source

–          Secondary source

–          analysis

• The use of book values to measure economic leverage

First, long term debt values on the balance sheet are assumed to approximate market values.

Second, leverage must be present on the balance sheet to be included in the analysis.

• The classification of an operating versus financial liability

Classify traditional working capital liabilities as operating liabilities and long term debt as a financial liability.

• Measurement of Asset Risk

Examines the leverage-returns relation after controlling for the firm’s asset risk.

–  Pilot Study

Interviews with a few FIIs, Financial Ananlysis, Mutual Fund Managers and Leading Brokers.

–          Two-step cluster analysis

First step, determine appropriate number of cluster. Build three-culster solution used to group investors having similar profiles across chosen variables.

Second step as initial starting values in an “iterative partitioning analysis” for final solution.

–          Multiple Regression

Carried out with portfolio performance as the dependent variables / factors as independent variables.

The Result:

• Conditional on operating risk, returns are decreasing in financial leverage.
• The ratio unlevered pricing multiple is positively related to future returns.
• The value premium associated with unlevered pricing multiple is increasing in leverage; this pattern is consistent with the evidence in Griffin and Lemmon that the book-to-market effect is increasing in the probability of bankruptcy.
• The magnitude of the authors’ leverage-return relation is negatively related to future returns is strongest (weakest) among low (high) unlevered pricing multiple deciles, this pattern is also consistent with the evidence found in griffin and Lemmon.

Conclusion

• A theoretical decomposition of the book-to-maket ratio and uses this framework to document a robust negative relation between future returns and leverage after holding the net operating asset dimension of the firm’s pricing multiple constant.
• The failure to explore potential reasons for the negative relation is, ultimately, the greatest weakness of the paper, and will likely serve as the impetus for future research projects.
• Documented results are consistent with a set of recent papers that document cross-sectional variation in the predictive ability of financial distress, leverage, and the book-to-market ratios.

The Result:

–       Stock is not considered to be risky if beta of the stock is high and viceversa.

–       Trading volume receives very high weight in the valuation process. Low trading volume implies poor liquidity and high risk. High trading atocks are positively valued whereas low trading stocks are negatively valued.

–       The fluctuation in foreign exchange rate dampens the market sentiment but affects the valuation of those stocks with export/import implication and hotel &tourism industry.

–       The cluster analysis,

Active style, cluster score greater than the respective mean score by at least one time standard deviation. They consider and react to the large number financial, economic, industry and firm variables.

Passive style, cluster score less than the respective mean score by at least one time standard deviation. do more analysis in respect forecasting and valuation stocks.

Balanced style, buying both the passive and active concept and occupying the middle ground.

Based on step-wise regression analysis found that none of the economic, industry and firm variables considered in the study could lead to variation in the portfolio performance.

Conclusion:

–          A factor has different impact on the valuation of different stock.

–          The use of large number of variables in the model does not lead to superior portfolio performance.

–          Suggest that active style is better than passive style and balanced style may be even better considering the high cost of being active players.

–  Fama and French (1992) provide strong evidence for size and book to market effects.

–  Bornholt (2006) extends these case by deriving a board class of mean risk asset pricing models that includes the CPAM as a special case.

–  Fama and French (1993) typically show increasing average excess returns and decreasing CPAM betas as book to market equity increases.

–  Fama and French (1992,1993,1995,1996) argue that if stocks are priced rationally, then size and book-to-market equity must proxy for underlying risk factors.

–  Fama and French (1993) use the three-factor model to explain the cross-sectional variation in the returns of 25 portfolios of stocks sorted on size and book-to-market equity comprising New York Stock Exchange (NYSE), American Stock exchange (AMEX) and National Association of Securities dealers Automated Quotation System (NASDAQ) stocks.

–  Fama and French (1992, 1993, 1995, 1996) argue that size and book-to-market equity must proxy for two underlying risk factors if stocks are priced rationally.

–  Willian Sharpe 1964 and John Lintner 1965 develop the Capital Asset Pricing (CAPM) made it possible to test the efficient market theory empirically.

–  Fama 1970, Sorensen 1982, Davidson and Froyer 1982, and Pearce and Roley 1983,1985 provided support for the EMH.

–  Flavin 1983,Kleidon 1986 also presented evidence that consistent with the efficient market.

–  Shiller 1979, 1981 and Rosenberg et al 1985 showed that the stock volatility is too large to support the theory.

–  Blume Crockett 1970, Sharpe 1966, Jensen 1968, Treynor 1965, and others use the CAPM to illustrate the implication of market efficiency.

–  Roll 1977 and Ross 1976 switched to other models such as the Arbitrate Pricing Model (APM) to explain the risk return trade off of investing in equities.

–  Jensen 1968 who used the market equation to calculate alphas for his funds and found a statistically significant number of funds with negative alphas.

–  Carlson 1970 recalculated the Sharpe and Jensen results emphasizing that the conclusions depend on the time period, type of fund and choice of benchmark.

–  Ippolito 1993 suggested that mutual funds, on average are successful on offsetting their expenses.

–  Grossman and Stiglitz’s 1980 result showed that net of all expenses mutual funds meet the market rate return, which supports the efficient market hypothesis.

–  Halpern, Calkins and Ruggels 1996, Kahn and Rudd 1995 and Bogle 1994 conclude that mutual fund managers could not posess any other information that is not already included in current stock prices.

–  Malkiel 1995 suggest that investors will be able to reduce costs by choosing the lowest soct investment which is usually index funds.

–  John Bogle 1999 using the Sharpe ratio compared the risk adjusted return of the nine Morningstar categories of mtual funds.

–  Nobel Laureate Franco Modigliani and her granddaughter, Leah Modigliani 1997 and is commonly referred to as the M squared measure.

–          The efficiency of mutual funds based on their board objective (growth, value, and blend)

–          Fama-French factor returns

–          Risk-free return

–          R_s : the average annual return on the fund

–          R_RF : the risk-free rate return, normally the annual yield on the 90-day Treasury bill.

–          σ_S : the annualized standard deviation for the fund.

M-square measure

–          R_s : the average annual return on the fund

–          R_RF : the risk-free rate return, normally the annual yield on the 90-day Treasury bill.

–          σ_S : the annualized standard deviation for the fund.

–          σ_M : the market standard deviation

1. 1. The reward Beta approach

Performs well empirically and is based on asset pricing theory.

1. 2. Empirical evaluation

Compares with the capital asset pricing model (CAPM) and the Fama-French three factors model.

Within sample-period

Calculated time-series estimates of each model’s parameters.

Out of sample test

Observed risk premium against within-sample CAPM estimates, and against within-sample reward beta estimates.

1. 3. Robustness

The reward beta approach consistently outperforms both the CAPM and the three factor model.

1. 1. Sharpe Ratio

The principal instrument used by researcher and investors to compare the return per unit of risk.

The obvious advantage is simplicity, as this is what makes it very popular among researchers.

The biggest criticism is that it measures only historical returns, while it is clear that past performance does not guarantee future results.

1. 2. M square measure

Calculates the performance of a portfolios, allowing an easy way to compare the returns of a portfolio with the overall market index.

The advantage is its economic benefit that allow investors to compute the optimal degree of leverage to reach the optimum rate of return.

The reward Beta approach

How effective these estimates will be depends on whether or not stocks in the same portfolio do have similar risk. If we accept risk based explanation of these two effects, then portfolio formed on size and book-to-market equity are composed of stock with similar risk, and so are amenable to the portfolio method of beta estimation.

Empirical evaluation

The reward beta model augmented with the size and book-to-market factor sensitivities. There is nothing to be gained by augmenting the reward beta model with these factor sensitivities.

Robustness

The poor performance of the CAPM in explaining the cross-section of average returns just adds to the already strong empirical evidence against the CAPM. The reward beta approach might give better result than those provided by estimating more-specialized models of expected returns.

Conclusions:

–          Both the CAPM and the Fama-French three factors model are known to have deficiencies.

–          The empirical evidence does not support the CAPM, whereas the three factors model lacks theoretical asset pricing justification and its appeal is limited in practices by estimation problems.

–          In contrast the reward beta approach is based on asset pricing theory and is strongly supported by empirical evidence reported in this paper.

–          These advantages make this approach a better choice across a range of applications.

–          Based on the average annual returns and standard deviations of selected group of mutual funds for the entire period show that mutual funds with the higher returns also experienced higher fluctuation in their return as expected.

–          Based average risk-adjusted returns Shar[e ratio and M-squared  measure, the Sharpe ratios are consistent with the risk-return trade-off, as the risk-adjusted rate of return for the riskier small funds is larger than for the larger funds. The result of M-square measure indicate the small-cap value funds, followed by the mid-cap value funds, have exhibited the highest risk-adjusted rate of return.

–          Based comparison of mean, we can make objective to rejected or accepted. If the P-value is less than 0.05 then the null hypothesis must be rejected.

–          The average rates of return and standard deviations of mutual funds during the first subperiod is associated with the stock market boom, the growth of dot com companies, and what Alan Greenspan reffered to as irrational exuberance. The result for second sbperiod seem to be more consistent with the risk-return concept as they expectedly show that higher risk mutual funds had higher standard deviation.

–          The result of comparison of means-market capitalization showing that there is a statistically significant difference in means, which implies that risk adjusted return of large, medium and small cap mutual funds are not equal. These finding is contradict the efficient market hypothesis.

–          Comparison of means and investment objectives showing that for both the entire period and the sub-periods, the average returns of value, blend and growth mutual funds are not equal. This is further evidence that contradicts the efficient market hypothesis.

Conclusions:

–       There was no certainty in expectation. If the market is efficient, the investor would be indifferent about investing in either type of mutual funds. In the absence of an efficient market, the investor needs to know the type of mutual funds that would bring higher risk-adjusted returns.

–       The market is not always efficient which makes it possible for investors or a mutual fund manager to earn higher expected returns.

–       The funds’ returns relative to their volatility. Small caps value funds have provided the highest risk-adjusted returns for the entire period, whereas the growth funds have exhibited lower returns.

–  (Morck et al (1988) and McConnell and Servaes (1990)) find non-linear relation between ownership structure and corporate value.

–  (McConnell and Muscarella (1985)) have shown that investment positively affects corporate value.

–  (Jensen and Meckling (1976) and Stulz (1988)) show that ownership structure affects corporate value.

–  (Jensen and Meckling (1976)) argue that ownership structure affects corporate value by its effect on investment.

–  (Morck et al (1988) and McConnell and Servaes (1990) empirically explore the overall relation between ownership structure and corporate value using Tobin’s Q as a proxy for corporate value)

–  (McConnell and Muscarella (1985) and Chan et al (1990)) explore the second stage of (Jensen and Meckling (1976)) implication concerning the link between investment and corporate value and find evidence in support of the hypothesis that investment affects corporate value.

Endogeneity issues :

–  (Morck et al (1988) and McConnell and Servaes (1990)) treat ownership structure as exogenous in exploring the relation between ownership structure and corporate value.

–  (Demsetz and Lehn (1985)) argue that ownership structure is endogenously determined in equilibrium.

–  (Kole (1994)) provides evidence of a revisal of causality in the ownership-corporate value relation, suggesting that corporate value could be a determinant of the ownership structure rather than being determined by ownership structure.

–  Finding suggests that, other things being equal, managers may prefer equity compensation when they expect their firm to perform well and consequently the value of the firm to increase.

–  (Murphy (1985)) finds that managerial compensation is strongly positively related to corporate performance, suggesting that ownership structure can represent an endogenous outcome of the compensation contracting process.

–  (Jensen and Murphy (1990)) report that executive pay goes up by only $3.25 for every $ 1000 change in shareholder wealth.

–  (Bebchuk et al.,2002 and Mueller and Yun, 1997) managers of large companies have sufficient discretion or power to design their own compensation contracts.

–  (La Porta, Lopez-de-Silanes, and Shleifer,1999) corporate governance in non Anglo Saxon countries offers the (minority) shareholder substantially weaker protection against expropriation.

–  (Franks and Mayer (2001)) report that out of 171 large corporations, 85% have a shareholder with at least 25% and %&% have a shareholder owning more than 50% of the equity.

–  (Boehmer (2000)) confirms that these figures are representative for all listed firms over the period 1985-1997.

–  (Law for German Stocks corporations (Aktiengesellschaften or AGs))explain the management board, the chairman of management board, the supervisory board, and shareholder.

–  (Edwards and Fischer (1994) and Gerum et al (1988)) show that proxy system allows bank to have more seats in the supervisory boards than their direct shareholdings would imply.

–  (Gugler and Yurtoglu 2003), studied that analyzed the ownership pyramids in Germany show that 60% to 72% of listed firms are ultimately controlled by families.

Variables:

–   INV: The investment level for firm

–   INS1_i : Insider ownership firm

–   INS2_i : will be zero if the insider ownership for firm is less than first breakpoint

–  INS3_i : will equal to zero if insider ownership of firm is below the secong breakpoint.

The simultaneously equations

Variables:

– Insider ownership = f (market value of firm’s common equity, coporate value, investmen, volatility earnings, liquidity, industry)

– Coporate value = g (insider ownership, investment, financial leverage, asset size, industry)

– Investment = h (insider ownership, corporate value, volatility of earnings, liquidity, industry)

Variables:

– C_it : Executive compensation (salary plus bonus)

–  P_it-1: Performance of the company (return on sales, assets or share returns)

–  S_it-t: Measure of lagged firm size (sales, total assets, employees)

–          X_it-1: The ownership and control structures of firms.

-The time lag of one year is usually used assuming that executive compensation is determined by ex-post firm-specific measures.

– β: can be thought of as a proxy for those factors that capture the relationship between pay and performance thereby revealing information about the managerial incentive contract.

The sensitivity compensation to shareholder wealth

Variables:

–  ∆_it :Managerial compensation

–  b∆ : Shareholder wealth

(separate a and b coefficients for different ownership categories)

1. The OLS regression model

Estimate a piecewise OLS linears regression of corporate value on ownership structure. Assume that two change in the slope coefficient on insider ownership. Estimate the following model of the investment equations to investigate whether ownership structure affects investmenrt.

The simultaneously equations

To address the potential endogencity effect, estimating a simultaneously equation system of ownership structure, investment and corporate value using the two stage least square method.

Step of analysis:

1. Noting that average executive pay has increased considerably from 1987 to 2003
2. Compared to firm performance, company size is much more important determinant of the level of executive compensation in Germany.
3. Agency problems caused by the separation of ownership and control exist because greater ownership concentration lowers the ability of executives to extract higher levels of compensation.
4. Considering the difference between direct vs ultimate ownership, we find that increases in the size of companies are associated with higher levels of executive compensation when voting rights deviate from cash flow rights.

Corporate value regression results

–    The relation between insider ownership and Tobin’s Q is significantly positive for ownership levels below 7% significantly negative for levels between 7% and 38% and positive but insignificant for levels above 38%.

–    The result show that the ownership variables are weaker, but still statistically significant at the 10% level.

Investment regression results:

–          There is significant non-monotonic relation between the level of investment and insider ownership.

–          The similarity of the size of coefficients on the insider ownership variables I both capital expenditures to the replacement cost of assets is higher than that of R&D expenditures to the replacement cost of assets.

–          Non-linear relation between insider ownership and capital expenditures remains significant.

Simultaneous equation regression results

–  The primary result is that endogencity indeed affects the result of OLS regressions, this finding holds irrespective of which measure of investment is used.

–  Suggest that managers in firms with higher corporate values or with better investment opportunities hold a larger fraction of their firm’s share.

– The result do not show any non-linear relation between insider ownership and investment.

–   In conclusion this findings in this section suggest that investment affects corporate value which in turn affects ownership structure thereby reversing the interpretation of the result from OLS regressions.

Robustness tests

–  Suggest that the result in Table 4 are not the outcome of a specification error.

–  Suggesting no influence of the potential outliers on the inferences from the simultaneous regression analysis.

Conclusions:

–  The evidence presented in the paper shows that endogencity significantly affects the inferences one can draw regarding the relation among ownership structure, investment, and corporate value.

–  OLS regressions suggest that ownership structure affects investment and therefore corporate value. These finding suggest that the implicit assumption of exogenous ownership structure severely affects the result from OLS regressions and leads to a misinterpretation of the result. The finding also bring into question the result in previous studies.

–  Investment affects corporate value which in turn affects ownership structure but not the reverse suggests that ownership may not be an effective incentive mechanism to induce managers to make value-maximizing decisions.

Both size and performance coefficient are significantly positive for the full sample. For every 10% increase in firm’s size, the average compensation paid to executives of the management board increases by about 1.7%. The ROA elasticity ranges from 0.106 to 0.27 means that size elasticity is highest in utilities.

2. Ownership structure and executive compensation

Firms categorized as “firm controlled” are those in which another domestic firm either owns 50% of the outstanding shares or another firm owns at least 25% and no one else owns more than 25%.

The ultimate cash flow right (CFR) associated with the voting right at direct level. The mean of DEV, which is a dummy variable indicating the deviation of cash flow right from voting rights is equal to 0.22, suggesting that 22% of the sample companies CFR deviate from voting right. This ratio naturally much higher in companies with a bank or firm as the largest shareholder at direct level.

–   The impact of direct ownership

The first measure is simply the largest direct shareholdings (LS) reports that this variable has a negative coefficient which is highly significant.

Second measure of ownership concentration is based on five dummy variables. The coefficient on the ownership dummies show that firms controlled by other domestic firms, foreign entities, and bank have lower compensation levels than firm in mixed category. On the other hand the coefficient on Bank dummy is almost three times higher, suggesting that managers of firms under the control of a bank receive almost 29% less than managers of firms in the mixed category.

–  The impact of ultimate ownership

Suggests that bank and foreign owned firms’ managers receive lower compensation than those under mixed category. Family again pays their managers significantly higher levels of compensation.

–   Deviation from one-share-one-vote

Suggest that increase in the size of German companies is associated with much higher level of executive compensation when voting right deviate from the cash flow rights. At the same time, the link between pay and performance becomes weaker in firms, where cash flow rights deviate from voting rights.

3. Ownership and pay-for-Performance Sensitivity

the OLS result show that firms ultimately owned by a Bank and by other entities (Mixed) reward their managers significant annual pay rises even if shareholder earn a zero return. In robust and median regression result, only firms that are ultimately owned by banks have statistically significant pay-for-performance coefficients.

Conclusions:

– Amounts to a substantial fraction of companies, earnings are an important issue to determine whether these payments are made in such a way to align the interests of shareholders and managers. Unfortunately our results suggest that this is hardly the case.

-Strong evidence of agency problems caused by the separation of ownership and control. Lack of control by ownership enables management to extract higher executive compensation, thereby confirming a study by Elston and Goldberg (2003) that used an older German dataset of the period 1970 to 1986. The identity of owners has a significant influence on the level of executive compensation. Whereas bank ownership substantially reduces the level of pay, family ownership has a significantly positive impact.

–       The strong relationship between profitability and compensation is absent in firms where ultimate owners increase their voting rights in excess of their cash flow right.

– The evidence provided by this paper is not consistent with superior corporate governance practices that align shareholders and managers interest, it is a good explanation why most German managers were reluctant to conceal more information concerning their compensation packages.