Estimating Risk Parameters

Estimating Risk Parameters
Aswath Damodaran
Stern School of Business
44 West Fourth Street
New York, NY 10012

Estimating Risk Parameters
Over the last three decades, the capital asset pricing model has occupied a central and
often controversial place in most corporate finance analystsí tool chests. The model
requires three inputs to compute expected returns ñ a riskfree rate, a beta for an asset and
an expected risk premium for the market portfolio (over and above the riskfree rate).
Betas are estimated, by most practitioners, by regressing returns on an asset against a
stock index, with the slope of the regression being the beta of the asset. In this paper, we
attempt to show the flaws in regression betas, especially for companies in emerging
markets. We argue for an alternate approach that allows us to estimate a beta that reflect
the current business mix and financial leverage of a firm.



The Role of Accounting in the Design of CEO Equity Compensation

The Role of Accounting in the Design of CEO Equity Compensation

Mary Ellen Carter

The Wharton School, University of Pennsylvania

Luann J. Lynch

Darden Graduate School of Business Administration, University of Virginia

Irem Tuna

The Wharton School, University of Pennsylvania

Current version: March 2006


We examine the role of accounting in firms’ equity compensation choices for CEOs. Studying ExecuComp firms in 1995-2001, we find that financial reporting concerns are positively associated with the use of options and negatively associated with the use of restricted stock. We also find that financial reporting concerns are positively associated with total CEO compensation. These results are consistent with the previously available favorable accounting treatment for stock options influencing firms’ choices related to equity compensation. To corroborate our findings, we examine changes in CEO compensation in firms that begin to expense options in 2002 and 2003. We find that these firms reduce the use of options and increase the use of restricted stock after they start expensing options. We find, however, that these firms do not reduce overall CEO compensation. Results suggest that favorable accounting treatment for stock options led to a higher use of options and lower use of restricted stock than would have been the case absent accounting considerations. That we detect no decrease in total CEO compensation upon expensing options suggests that firms find it difficult to downsize hefty executive pay packages that may have resulted from the favorable accounting treatment for options. The results confirm that financial reporting costs play a role in determining CEO compensation.

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Pricing for Systematic Risk

Pricing for Systematic Risk

Frank Schnapp
Director of Actuarial Analysis and Research
National Crop Insurance Services, Inc.


In recent years, financial methods have emerged as the dominant approach for establishing insurance profit loadings. Financial theory suggests that prices should reflect systematic risk only, with no reward for diversifiable risk. This principle is applied to the pricing of insurance exposures actively traded in a secondary market. The resulting Systematic Risk Pricing Model differs from the Capital Asset Pricing Model in that it determines the price rather than the rate of return for each exposure. In order to reconcile the two pricing models, the amount of capital invested in a security in the Capital Asset Pricing Model is reinterpreted as the price for the exposure. Under the Systematic Risk Pricing Model, the price for the exposure is determined without regard for the insurer's cost of capital. In this method, an exposure's rate of return represents the profit margin, that is, the expected profit for an exposure in relation to its price. Due to the inconsistency of the CAPM with this result, the interpretation of CAPM rate of return as the market capitalization rate used to discount fiature income to present value is abandoned. An in-depth examination of the CAPM identifies a number of conceptual errors with the model, the most serious of these being that the CAPM substitutes the variability of the price of the exposure over time for the true risk of the exposure. A mathematical derivation of the CAPM from the Systematic Risk Pricing Model is presented to identify the faulty assumptions underlying the model.

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Dissertation 01

Corporate Governance, Earnings Management, and the Information Content of Accounting Earnings: Theoretical Model and Empirical Tests

A dissertation submitted to the Faculty of Business in candidacy for the degree of Doctor of Philosophy

Turki Bugshan
Bond University
Queensland 4229


The primary objective of this dissertation is to show that corporate governance affects the value relevance of earnings in the presence of earnings management. The role of corporate governance is to reduce the divergence of interests between shareholders and managers. The role of corporate governance is more useful when managers have an incentive to deviate from shareholders’ interests. One example of management’s deviation from shareholders’ interests is the management of earnings through the use of accounting accruals. Corporate governance is likely to reduce the incidence of earnings management. Corporate governance is also likely to improve investors’ perception of the reliability of a firm’s performance, as measured by the earnings, in situations of earnings management. That is, corporate governance will be value relevant when earnings management exists. The results of this research support these propositions.

In this thesis, the value relevance of earnings is measured using the earnings response coefficient. Earnings management is measured using the magnitude of abnormal accruals as estimated by the modified Jones (Dechow et al., 1995) model. A review of the corporate governance literature revealed nine attributes that were expected to impact on shareholders’ perception of earnings reliability due to their role in enhancing the integrity of the financial reporting process. The nine attributes represent three categories of corporate governance: 1) organisational monitoring; 2) incentive alignment; and 3) governance structure.

Organisational monitoring includes ownership concentration, debt reliance, board independence, and the independence and competence of the audit committee. Incentive alignment includes managerial ownership and independent directors’ ownership. Governance structure includes CEO dominance and board size. These attributes are used in this study to assess the impact of corporate governance on earnings management and the information content of earnings.

Information dynamics models, such as the Ohlson (1995) model provide a testable
pricing equation that also identifies the role non-accounting information (i.e. corporate
governance) plays in determining firm value. Based on Ohlson’s (1995) model, the
change in value model, as developed by Easton and Harris (1991), is modified to include
the proposed interaction between corporate governance and earnings management.

Pooled GLS regression is employed as the primary technique to estimate the coefficients. Four hypotheses are used to test the connections among corporate governance, abnormal accruals, and the earnings response coefficients. The returns-earnings model is used to test the interaction coefficients after incorporating earnings management (Hypothesis Two), corporate governance (Hypothesis Three), or both These coefficients are then examined using the Wald test to find out

(Hypothesis Four). whether the earnings response coefficients after incorporating indictors of earnings reliability are significantly different from the earnings response coefficients irrespective
of any propositions. The sample was drawn from the top ASX 500 listed companies for the years 1997 to 2000. The final sample contained 778 firm-year observations. Certain industries (financial, regulated, and mining) were excluded from the sample. One of the reasons the period 1997-2000 was chosen is due to the expected impact of the Asian currency crisis on increasing firms’ incentive to manage earnings.

The results reveal that: 1) board size and audit committee independence are negatively associated with the magnitude of abnormal accruals; 2) incorporating the magnitude of abnormal accruals to the returns-earnings model does not significantly alter the earnings response coefficient; 3) the earnings response coefficients are significantly different after incorporating CEO dominance and independent directors’ ownership; and 4) conditioning on the magnitude of abnormal accruals improves the explanatory power of the interaction between corporate governance and earnings over share returns.

Although not all corporate governance attributes suggested in the literature impact on investors’ perception of a firm’s performance, the primary proposition that corporate governance affects this perception when earnings are managed is supported. The primary contribution of the study is finding evidence supporting the moderating effect of earnings management on the relationship between corporate governance and the value relevance of earnings. These results validate Hutchinson and Gul’s (2004) claim that the role of corporate governance attributes in firm performance should be evaluated in concurrence with a firm’s organisational environment. Future research should control for corporate governance and earnings management, as indicators of earnings reliability, when using returns-earnings regressions to address a research question.

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Modeling High-Stakes Consumer Decisions in Repeated Contexts: The Problem of Mammography Adherence Following False Alarm Test Results

Modeling High-Stakes Consumer Decisions in Repeated Contexts: The Problem of Mammography Adherence Following False Alarm Test Results

Barbara E. Kahn
Mary Frances Luce


Consumers often have to decide whether to acquire information in stressful, high-stakes domains. We study women in mammography waiting rooms to test how the information-gathering experience influences intentions regarding their next scheduled mammogram. In particular, we investigate how a patient’s "false alarm" result on one occasion (i.e., a mammogram’s indication that cancer is present when a ‘more accurate’ follow-up test reveals it is not) affects willingness to get a regularly scheduled mammogram the next time it is due. We adapt the normative value of information framework by hypothesizing that stress may moderate reactions to a false positive test result. Study 1 demonstrates that a false alarm can delay planned testing adherence but only when that false alarm test result has no implications about the likelihood of future cancer. For patients receiving a false alarm result, information providing either problem-focused coping support by stressing the patient’s control or emotion-focused coping support by stressing the frequency of false alarm results mitigates negative future adherence effects. These reactions to false alarm results are moderated by stress, a finding that is developed in Study 2 where we show that stress alters patients’ assessments of the utilities associated with testing outcomes. Study 3 shows that, in the presence of a false alarm result, women with actual false alarm history who experience stress are more likely to delay their next mammogram whereas women without actual false alarm history who experience stress are less likely to delay their next mammogram.

KEYWORDS: Value of Information, Decision-making under uncertainty, Behavioral Decision Theory; Stress

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Discovery and Communication of Important Marketing Findings: Evidence and Proposals

Discovery and Communication of Important Marketing Findings:
Evidence and Proposals (31 Page)

J. Scott Armstrong
October 8, 2001


I conducted a review of empirical research on scientific publication. This led to three criteria for identifying whether findings are important: replicability, validity, and usefulness. A fourth criterion, surprise, applies in some situations. Based on these criteria, important findings resulting from academic research in marketing seem to be rare. To a large extent, this rarity is due to a reward system that is built around subjective peer review. Rather than using peer review as a secret screening process, we should use it as an open process to improve papers and inform readers. Researchers, journals, business schools, funding agencies, and professional organizations can all contribute to improving the process. For example, researchers should do directed research on papers that contribute to principles, journals should invite papers that contribute to principles, business school administrators should reward researchers who make important findings, funding agencies should base decisions on researchers' prior success in making important findings, and professional organizations should maintain web sites that describe what is known about principles and what research is needed on principles.
Keywords: competing hypotheses, peer review, principles, replication, surprising findings, validity
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The Investment Opportunity Set and Industry Specialization by Auditors

The Investment Opportunity Set and Industry Specialization by Auditors
Steven F. Cahan,
Jayne M. Godfrey ,
Jane Hamilton , and Debra C. Jeter


While auditor industry specialization has attracted widespread interest in the academic literature, one of the most fundamental questions remains unanswered: Why do some industries lend themselves to more intensive auditor specialization than others? In this study, we posit that IOS plays an important role in determining whether an industry is an attractive target for auditor specialization. We argue that when industry-specific IOS is high, auditors must make costly industry-specific investments that allow them to offer a differentiated product and create entry barriers for other audit firms. However, when a large component of IOS is unique to specific firms within an industry (i.e., IOS is highly variable within the industry), this creates unique knowledge requirements for the firm’s auditor, and it is more difficult to transfer knowledge and spread costs across clients in that industry. Using two different measures of IOS and three alternative industry classification schemes, we present evidence that auditor specialization is increasing in industry IOS levels and decreasing in within-industry IOS variability.



Jeffrey Pontiff
Michael J. Schill

This paper uses a new approach to assess return behavior after seasoned equity offerings. Our approach recognizes that sophisticated investors are motivated to correct mispricing, although the magnitude of their activity is influenced by arbitrage costs. This approach avoids inference problems due to model misspecification or data snooping. The evidence supports the contention
that firms that conduct seasoned equity offerings are overpriced. Our findings imply that, since mispricing associated with seasoned equity offerings is persistent in the long-run, holding costs play an important role although transaction costs do not. In fact, holding costs dominate the size effect documented by previous research.

The Theory of Financial Intermediation

The Theory of Financial Intermediation
Franklin Allen
Anthony M. Santomero

Traditional theories of intermediation are based on transaction costs and asymmetric information. They are designed to account for institutions which take deposits or issue insurance policies and channel funds to firms. However, in recent decades there have been significant changes. Although transaction costs and asymmetric information have declined, intermediation has increased. New markets for financial futures and options are mainly markets for intermediaries rather than individuals or firms. These changes are difficult to reconcile with the traditional theories. We discuss the role of intermediation in this new context stressing risk trading and participation costs.

Keywords: intermediation, risk management delegated monitoring, banks, participation costs

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Are Internal Capital Markets Good for Innovation?

Are Internal Capital Markets Good for Innovation?

Peter G. Klein
Contracting and Organizations Research Institute
University of Missouri

Which type of firm is more innovative: the decentralized, diversified corporation or the smaller, more narrowly focused “entrepreneurial” firm? According to one argument, diversified corporations can do more R&D because their operating units have access to an internal capital market. Other writers argue that decentralized, diversified firms over-rely on financial accounting criteria to evaluate the performance of their operating units, discouraging divisional managers from investing in projects like R&D with long-term, uncertain payoffs. This paper uses a comprehensive sample of diversified and nondiversified firms from 1980 to 1999 to study the relationship between diversification and innovation. I find a robust negative correlation between diversification and R&D intensity, even when controlling for firm scale, cash flow, and investment opportunities. Industry-adjusted R&D—the difference between the R&D intensity of a diversified firm and the R&D intensity it would most likely have if its divisions were standalone firms—is negative, consistent with the hypothesis that diversification reduces innovation by discouraging R&D investment. However, other evidence suggests that internal-capital-market inefficiencies, rather than managerial myopia, are driving the negative relationship between diversification and innovation.

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Cecilia Lambert*
Christopher Lambert**

Until recently, Australian companies have been precluded from adopting equity accounting for investments in associated companies in the consolidated accounts. As reported profits were based on the cost method (albeit with note disclosures utilising equity accounting procedures), this paper investigates the incentives of Australian firms to manage earnings in a reporting environment which facilitated opportunism. It is argued that the higher the ex ante probability of managing accounting earnings from investments in associates, parties will contract to remove those incentives by restricting the accepted set of accounting procedures to equity accounting. Opportunism is more likely to be observed for firms for which it is inefficient to ex ante specify the method of accounting for associates. The ability to act opportunistically is defined as the degree of influence which an investor exercises over the financial and/or operating policies of its investees. The results are confirmatory. For firms which have a lower ex ante probability of managing earnings, use of the cost method significantly improves consolidated return on investment compared with returns calculated using the equity method. Firms which are more likely to choose the equity method for efficiency reasons have an insignificant difference between cost and equity returns.



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The Management Bible

The Management Bible
The Management Bible is the most comprehensive book on the topic of management available anywhere. It offers in-depth coverage of the entire range of essential topics for today’s managers and supervisors—from beginners to seasoned veterans—and includes practical, effective solutions for the everyday problems every manager faces. In addition, the book also includes proven tips and tactics that help managers grow into more effective, efficient leaders. Authors Bob Nelson and Peter Economy reveal everything you need to know to keep up with today’s rapidly changing business environment, including such topics as hiring and firing, motivating employees, development and coaching, delegating authority, communication and teamwork, and much more. Bob Nelson, Peter EconomyISBN: 0-471-70545-4Paperback304 pagesFebruary 2005

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