Why Do Managers Avoid EPS Dilution? Evidence from Debt-Equity Choice

49 Pages Posted: 1 Sep 2009 Last revised: 16 Aug 2013

Rong Huang

City University of New York (CUNY) - Stan Ross Department of Accountancy

Carol A. Marquardt

City University of New York (CUNY) – Baruch College

Bo Zhang

School of Business, Renmin University of China

Date Written: August 9, 2013

Abstract

Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt-equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making.

Keywords: EPS, Dilution, Executive Compensation,Debt-Equity Financing, Agency Conflicts

JEL Classification: G32, J33, M41

Suggested Citation

Huang, Rong and Marquardt, Carol A. and Zhang, Bo, Why Do Managers Avoid EPS Dilution? Evidence from Debt-Equity Choice (August 9, 2013). Review of Accounting Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1464496 or http://dx.doi.org/10.2139/ssrn.1464496

Rong Huang (Contact Author)

City University of New York (CUNY) - Stan Ross Department of Accountancy ( email )

One Bernard Baruch Way, Box B12-225
New York, NY 10010
United States
(646)312-3204 (Phone)

Carol Marquardt

City University of New York (CUNY) – Baruch College ( email )

One Bernard Baruch Way, Box B12-225
New York, NY 10010
United States
646-312-3241 (Phone)

Bo Zhang

School of Business, Renmin University of China ( email )

59 Zhongguancun Street
Haidian District
Beijing, 100872
China
86-10-62514992 (Phone)

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