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1. Introduction
This paper investigates the short- and long-term effects of the level of earnings per share (EPS) on corporate capital structures. I further examine whether the primary channel through which EPS influences leverage is EPS management actions, and which characteristics of a firm have impact on the relationship between EPS and capital structures. To the best of my knowledge, this is the first paper that studies the long-term side effect of EPS management on firms’ real financial policies.
Although traditional corporate finance theory suggests that EPS dilution is irrelevant in firm valuation and corporate policy (Modigliani and Miller 1958;
Brealey, Myers, and Allen, 2007), it has been found that EPS dilution affects corporate managers’ decisions of debt-equity financing and of repurchasing their companies’ stocks. Corporate managers are likely to consider EPS as an important factor when making financing decisions for the following reasons.
First, managers may actively manage reported EPS as investors and researchers generally consider EPS to be one of the most important variables in determining the profitability of a company and estimating a share’s fundamental price. Because investors reward firms that report consistent EPS growth, consistently meet analysts’
EPS forecasts, and avoid EPS disappointments, previous empirical studies show that managers are motivated to opportunistically manage EPS to meet analyst expectations (Skinner and Sloan, 2002; Gunny, 2010), avoid losses (Burgstahler and Dichev, 1997), and maximize stock price (Teoh, Welch, and Wong, 1998a, b).
Second, a growing stream of empirical literature shows that executives’ annual bonus compensation contracts are frequently based on EPS performance (Ittner, Larcker, and Rajan, 1997; Kim and Yang, 2010; and Huang, Marquardt, and Zhang,
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1985; Bens, Nagar, Skinner and Wong, 2003).Brealey and Myers (1996) thus indicate that there is a common belief among executives that share issuance dilutes EPS, and they try to avoid EPS dilution arising from issuing new equity (Brealey and Myers call this view a “fallacy”).
Correspondingly, survey evidence shows that, among the firms that considered issuing common equity, out of a total of 11 factors, EPS dilution is the most important factor affecting their decision on common equity issuance (Graham and Harvey, 2001).1 Furthermore, recent empirical work shows that the managers’ concerns on the level of EPS affects their decisions regarding the choice between debt and equity, and whether to repurchase their company's stock.2
Empirical evidence shows that managers are reluctant to issue equity if it dilutes the accounting measures of performance or value. For example, Hovakimian, Hovakimian, and Tehranian (2004) examine how firms choose the form of financing by focusing on firms that issue both debt and equity. They find that for about half (44.5%) of debt issuers, issuing equity would dilute the EPS more than issuing debt would. The same is true for only 25% of dual issuers and 20% of equity issuers. The results show that managers are concerned about EPS dilution when they seek external financing. In addition, Huang, Marquardt, and Zhang (2014) show that avoiding EPS dilution helps to resolve underleveraging (as suggested by Fama, 1980), but firms are
1 Graham and Harvey (2001) find that more than two-thirds of CFOs agree that “EPS dilution” was an important or very important consideration in issuing equity. In that survey as a whole, EPS dilution is regarded as the most important factor among the 11 factors considered in the decision to issue common stock.
2 See Fama (1980), Graham and Harvey (2001), Hovakimian, Hovakimian, and Tehranian (2004), and Huang, Marquardt, and Zhang (2014) for literature related to the effect of EPS on choice between debt-equity issues, and see Bens, Nagar, Skinner and Wong (2003), Brav, Graham, Harvey and Michaely (2005), Oded and Michel (2008), Skinner (2008), Young and Yang (2011), Farrell, Unlu and Yu (2014), and Almeida, Fos, and Kronlund (2015) for literature related to the effect of EPS on stock repurchases.
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reluctant to address an overleveraging problem when an equity issue would reduce reported EPS.
For literature related to the effect of EPS on stock repurchase, Brav, Graham, Harvey and Michaely (2005) survey 384 financial executives to determine the factors that drive dividend and share repurchase decisions and report that three-fourths of survey respondents indicate that increasing EPS is an important factor affecting their distribution decisions. A substantial body of empirical literature provides evidence regarding the use of share repurchases as a mechanism to boost EPS (Bens, Nagar, Skinner and Wong, 2003; Hribar, Jenkins, and Johnson, 2006; Oded and Michel, 2008;
Almeida, Fos, and Kronlund, 2015), and it is one commonly cited reason behind the increased use of share repurchase programs (see, for example, Grullon and Ikenberry, 2000).
The effects of EPS on financing decisions and on payout policy both have implicit implications in corporate capital structures. As such, this paper explicitly identifies whether, how, and why the level of EPS matters for corporate capital structures. One expects at least a mechanical, short-run impact. The question, however, is whether fluctuations in EPS have a very long-run impact on capital structures. If firms subsequently rebalance away the influence of EPS on the leverage ratio, as the trade-off theory suggests, then EPS would have no persistent impact on capital structures. The significance of EPS for capital structure is therefore an empirical issue.
First, I examine the short-term effect of EPS on capital structure. My results show that, annual changes in firms’ leverage ratios are significantly inversely influenced by the level of EPS, which is consistent with the argument that a lower (higher) EPS correlates with a higher probability that a firm will induce an increase
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(decrease) in its debt ratio. These inferences are robust whether leverage is measured in book or market values or whether various control variables are included. I also find that EPS has strong and persistent effects on firms’ capital structures. I employ the external finance weighted-average EPS to evaluate the effect of past EPS on leverage ratios. The weighted-average EPS is a weighted average of a firm’s past EPS which takes high values for firms that raised their external finance, whether equity or debt, when their EPS were high. Regression results show that a firm’s leverage is strongly negatively related to its measure of historical EPS. The main finding is that managers do not rebalance to some target capital structures, and thus historical valuations of EPS to some extent explain why leverage ratios differ across firms.
I then use the passage of the Sarbanes-Oxley (SOX) Act of 2002 as a natural experiment to investigate whether the negative relationship between EPS and capital structure is a result of attempts to manage EPS through debt-equity choices or stock repurchases. Cohen, Dey, and Lys (2008) study the consequences of the regulatory changes and show that the level of real earnings management (REM) increased significantly. Because the actions of mangers to employ debt-equity choices or stock repurchases to manipulate EPS fall into the category of REM, I find that SOX reinforce the negative relationship between EPS and annual changes in leverage. The result suggests that the primary channel through which EPS may influence leverage is via actions of REM.
Next, I undertake two separate analyses to evaluate the persistence and find that the influence of past EPS on capital structures is persistent. First, I examine the effect of the weighted-average EPS on the value of leverage many years later. The results show that the effect of the weighted-average EPS on leverage has a half-life of well over 10 years. That is, the current capital structure depends strongly on variations in
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the EPS over the ten previous years or more, even controlling for the last year value of EPS and other control variables. Second, I regress cumulative changes in leverage from the first year of Compustat data to subsequent dates against the weighted-average EPS. The result shows that the weighted-average EPS not only influence leverage levels, but also influence cumulative changes. As such, EPS have an important impact on leverage that persists and accumulates over time.
I consider two economic mechanisms through which EPS negatively affects leverage: managerial equity-based compensation channel and corporate governance channel. The results show that the effect of EPS on capital structures is more pronounced when the CEO’s potential total compensation is more closely tied to the value of stock and option holdings. Managers with higher stock and option compensation are more sensitive to short term stock prices, and pay greater attention to EPS when they finance externally and when they repurchase stocks (Bens et al., 2003; Bergstresser and Philippon, 2006; Huang et al., 2014). Although corporate governance could also strength the negative effects of EPS on capital structures according to Stein’s (1989) hypothesis that earnings management behavior is concentrated among firms with strong corporate governance, I only find limited evidence to support this argument.
The strong and persistent effect of EPS on capital structures is essentially different from traditional theories of capital structures, and these phenomena are hard to explain with traditional theories of capital structures. In the trade-off theory, there is a long-term debt ratio that will minimize the cost of capital. The trade-off theory predicts that temporary fluctuations in a firm’s characteristics, such as EPS, should at most have temporary effects. My findings show that EPS has very persistent effects on capital structures, however. In the pecking order theory, firms are financed first
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with internally generated funds, then they issue debt if internal funds prove insufficient, and finally they use equity only as a last resort. In essence, the pecking order theory involves rational investors recognizing adverse selection and discounting equity financing, whereas the effect of EPS on capital structures involves irrational investors. In the EPS effect story, investors are irrational and can be tricked by managers’ EPS management. To be more precise, if investors are rational, managers can no longer benefit from managing EPS through debt-equity choice or stock repurchase, and in such case EPS would not influence companies’ capital structures.
The market timing theory proposed by Baker and Wurgler (2002) also suggests that investors are irrational. Baker and Wurgler argue that a firm’s observed capital structures reflect its cumulative ability to sell overpriced equity shares and raise underpriced equity shares, thus current capital structure is strongly related to historical market values. Market timing benefits ongoing shareholders at the expense of entering and exiting ones. The EPS effect, however, puts more emphasis on contracting and entrenching explanations. As such, the EPS effect on leverage is more pronounced when managers are concerned about compensation that is dependent on stock performance.
My study is built on those documenting EPS as an important factor in determining the choice of external financing and stock repurchase (Grullon and Ikenberry, 2000; Bens et al., 2003; Hovakimian et al., 2004; Hribar et al., 2006; Oded and Michel, 2008; Huang et al., 2014; Almeida et al., 2015). However, these studies at most implicitly suggest the short-term, temporary effect of EPS on capital structure.
This is the first study to sift through these implicit meanings, and show EPS as a substantial and persistent component of cross-sectional variation in capital structures.
My findings indicate that EPS is a significant concern when managers make external
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financial or corporate payout policy, which thus has a large and decades-long impact on corporate structures.
The remainder of the paper is organized as follows. Section 2 describes the data and summary statistics. Section 3 presents the empirical results of EPS effect on capital structures, and section 4 investigates its persistence. Section 5 examines cross-sectional heterogeneity in the negative effect of EPS on leverage to better understand the economic mechanisms behind the relationship between EPS and leverage. Section 6 concludes the paper.