Your browser is currently set to block JavaScript.

For full functionality of this site it is necessary to enable JavaScript. Here are the instructions how to enable JavaScript in your web browser.

After enabling javascript, please refresh the page to go back to experts.com site with full functionality

Would you turn off/on JavaScript?

It's a widely used language that makes the web what it is today, allowing for websites to be more responsive, dynamic, and interactive. Disabling JavaScript takes websites back to a time when they were simple documents without any other features.

What are the advantages of using JavaScript?

Speed. Since JavaScript is an 'interpreted' language, it reduces the time required by other programming languages like Java for compilation. JavaScript is also a client-side script, speeding up the execution of the program as it saves the time required to connect to the server.

banner ad
Experts Logo

articles

Do Managerial Motives Influence Firm Risk Reduction Strategies?

As originally published by The Journal of Finance, May, 1995

By: Dr. Donald M. May, PhD, CPA
Tel: 212-390-0595
Email Dr. May


View Profile on Experts.com.


ABSTRACT

This article finds evidence consistent with the hypothesis that managers consider personal risk when making decisions that affect firm risk. I find that Chief Executive Officers (CEOs) with more personal wealth vested in firm equity tend to diversify. CEOs who are specialists at the existing technology tend to buy similar technologies. When specialists have many years vested, they tend to diversify, however. Poor performance in the existing lines of business is associated with movements into new lines of business.

AGENCY THEORY IS RICH in models that explain how differences in risk aversion between managers and shareholders can impose costs on shareholders. However, to date there is little evidence that managers' personal risk preferences are associated with firm decisions. This study presents such evidence. I do this by examining how CEO and firm characteristics are associated with firm risk attributes. First, I examine how the diversification level sought in a given acquisition is related to the CEO's human capital vested in the firm, equity wealth vested in the firm, asset specialization, and past performance. I then examine whether these same CEO characteristics are associated with other firm risk attributes such as debt ratios and equity variances.

Such an examination is important in light of recent evidence that diversification strategies do not necessarily add value for shareholders. For example. Comment and Jarrell (1995) find that firm performance is Increasing in firm focus level. Lang and Stulz (1994) conclude that firms diversify when they have exhausted growth opportunities in their primary industry, but that such diversification strategies do not necessarily benefit shareholders. Berger and Ofek (1995) compare the stand-alone value of diversified firm segments to specialized firms and find a 13 percent to 15 percent value loss from diversification.

One explanation for why firms pursue risk reducing strategies such as diversification is presented in Amihud and Lev (1981). They argue that imperfect monitoring and contracting allow managers to take actions that are in their own best interests and not necessarily those of shareholders. One such action is firm-level diversification. The problem arises because shareholders can easily control the risk of their individual portfolios in the capital market. However, managers can only reduce their human capital risk at the firm level. Thus, for managers, diversification may have a positive net present value (NPV), while for shareholders it may have negative value. Consistent with their theory, Amihud and Lev find that conglomerate mergers are more numerous when shareholdings are widely dispersed, because in such cases managers are better able to pursue policies that serve their own interests.

This article extends the work of Amihud and Lev, who examine differences in management's opportunity to pursue risk reduction. Here I examine crosssectional differences in CEO motive to pursue risk reduction. My proxies for CEO motive are years with the firm, proportion of personal wealth vested in firm equity, asset specific expertise, and the firm's recent performance. I find that CEOs tend to pursue equity variance, reducing acquisitions when they have higher levels of personal wealth vested in firm equity. CEOs with backgrounds specific to their firm's existing technology tend to acquire similar technologies. However, when specialists have many years vested with the firm, they tend to diversify. This is consistent with the view that, as human capital becomes more firm specific, the personal gains to diversification outweigh the gains to specialization. (Shleifer and Vishny (1989)). I also find, similarly to Lang and Stulz (1994), that firms tend to move into new lines of business when they are performing poorly in their existing business. Also consistent with the human capital diversification hypothesis, I find a negative relation between CEO years vested and firm debt ratios as well as equity return variances.

The evidence presented in this paper offers empirical support for the view that firm-level risk reduction decisions are affected by managerial objectives. This could explain why strategies such as diversification occur even when they do not increase shareholder value. By pointing out the characteristics that influence management's desire to reduce risk, these findings may also be helpful in designing contracts and control mechanisms that reduce such agency conflicts. That is, they may indicate when such mechanisms may be most appropriate.

The remainder of this article is organized as follows. In Section I, I describe and motivate the dependent and independent variable proxies. I describe the sample and present the findings in Section IL I conclude with a summary and implications in Section III.

I. Independent and Dependent Variable Proxies

A. The Independent Variable Proxies-CEO and Firm Characteristics

. . .Continue to read rest of article (PDF).


Donald M. May PhD, CPA, Managing Partner at DMA Economics, LLC, possesses over 30 years of Valuation and Economic Damages experience. He implements a broad range of damage analyses and valuations for clients, including billion-dollar investment funds under SEC investigation as well multi-national firms involved in intellectual property disputes, consumers in product mislabeling cases, and small to mid-sized businesses involved in complex commercial litigation.

©Copyright - All Rights Reserved

DO NOT REPRODUCE WITHOUT WRITTEN PERMISSION BY AUTHOR.

Related articles

Kenneth-Lehrer-photo.jpg

10/31/2013· Economics

Inflation and the Middle Class - 2011 Onwards

By: Dr. Kenneth E. Lehrer

A person does not have to be too old to truly remember the times (mid 1960's and early 1970's) when gas stations gave away trinkets, toys, glasses, tableware and even "Green Stamps" that could be redeemed for valuable "merchandise" when you purchased a few extra gallons of gasoline. How eager the major gasoline companies were to stimulate sales, create demand and obtain their growing share of middle class consumer dollars.

Kenneth-Lehrer-photo.jpg

4/23/2014· Economics

The Petroleum Matter or Mess?

By: Dr. Kenneth E. Lehrer

At the present time, the fundamental question is whether the petroleum "event" will turn out to be a blessing or a curse for the United States, especially the nations middle class. The increasing price of petroleum, especially if it remains at elevated levels for a prolonged period of time (say 6 months or longer) could have a pronounced negative effect on the Middle Class. These effects can be broken down into three (3) major categories - direct, indirect and subsequential.

expert_placeholder

5/6/2011· Economics

Why Juries Can Be Trusted

By: Dr. Stan V. Smith

Setting aside the one case in 100,000 that makes headlines, are juries generally capricious and liberal? Are verdicts frequently unreasonable?

;
Experts.com-No broker Movie Ad

Follow us

linkedin logo youtube logo rss feed logo
;