What is the opportunity cost of private benefits of control? Using dollar cost of corporate giving to measure private benefits of control, we show in a recent study that (i) the consumption of private benefits creates a managerial aversion to new external financing due to the threat of enhanced scrutiny from external capital providers and (ii) this aversion to external financing leads to non-optimal corporate investment decisions. In addition, we provide new evidence that these investment distortions reduce shareholder wealth.
One implication of Jensen’s (1986) free cash flow view of the manager-shareholder agency problem is that each dollar of rent extraction reduces internal cash flow available to finance new corporate investment by one dollar. So, if corporate giving represents a private benefit, then we expect to find that the investment-cash flow relation is affected by corporate giving. We trace the accounting implications of discretionary charitable contributions, which are decided based on cash flow anticipations or realization, on firm cash flow and then assess its effects on corporate investment. If private benefits of corporate giving represent a drain on cash flow, then we should observe that corporate giving has a negative effect on investment, at least for firms not needing or wanting to raise more external capital. Based on a standard investment-cash flow analysis, our private benefits measure can be treated as an unnecessary expense, and without its recognition, the estimated investment-cash flow relation overemphasizes the role of frictions in the capital market, misleadingly suggesting the lack of external financing availability for profitable investment projects.
We find that in firms with higher levels of cash flow, corporate giving reduces a firm’s investment. Specifically, a one standard deviation increase in corporate giving reduces corporate investment by 1.69 percent. In other words, corporate giving reduces cash flow available for internally financed investment. Consequently, the sensitivity of investment to internal cash flow (adjusting for corporate giving) is significantly lower for firms that spend more on managerial private benefits. As a result, firms with free cash-flow problems may erroneously be labeled as cash constrained under the conventional analysis of the investment-cash flow relation. Our study offers an alternative perspective on this estimated relation that raises fresh doubts about the interpretation of the conventional investment-cash flow estimates as a reliable measure of a firm’s financial constraints.
To establish a causal relation, we conduct a quasi-natural experiment using the 2003 dividend tax cut, which reduced the personal income tax rates on dividends from a maximum rate of 35 percent to 15 percent (Chetty and Saez 2005). By cutting the personal tax rate on dividends by more than half, the 2003 tax law substantially raised the after-tax cost of private benefit consumption. Using this approach, Masulis and Reza (2015) show that corporate giving declined after the 2003 dividend tax cut. We extend their analysis by examining whether subsequent reductions in corporate giving result in increased investments in firms with high levels of cash flow and that find that this is indeed the case. We also show that the tax effect is more pronounced in the subsample of firms where CEOs bear higher costs of corporate giving. Therefore, this experiment measures an effect that is strictly due to the change in the cost of corporate giving.
In yet another experiment, we consider the effect of hedge fund activism on corporate charitable contributions. Brav, Jiang, Partnoy, and Thomas (2008) find improved stock performance after hedge fund activism reflects a reduced free cash flow problem when managers face more intense monitoring. The improved firm governance structure due to hedge fund activism provides an attractive test of our hypothesis as this allows us to observe changes in corporate giving that are exogenously forced on firms. Consistent with Brav, et al (2008), we find that firms reduce charitable contributions substantially after hedge funds acquire more than 5 percent ownership. In regression analysis, we also show that the reduced amount of corporate giving is associated with increased corporate investment in firms with high cash flow, confirming our earlier findings supporting the Jensen’s free cash-flow hypothesis.
Since net shareholder wealth effects are observable in M&A transactions, we next focus on acquirer stock returns after the deal announcement. Consistent with the free cash flow hypothesis of Jensen (1986), we document that acquirers with high private benefits and high cash flow experience significantly lower returns on acquisition announcements, suggesting that shareholders use the extent of corporate charitable giving to form an estimate of the likely managerial rent extraction from newly acquired assets. Moreover, the effect is concentrated in the samples of diversifying and cash-financed acquisitions. While diversifying acquisitions can reduce a manager’s idiosyncratic risk even if the investments are not value enhancing (Harford 1999), cash-financed transactions help managers to avoid monitoring by the external capital market. Major diversifying acquisitions also make it easier for managers to hide the extraction of personal benefits and poor managerial performance since comparisons of firm performance metrics across time are made more difficult, if not impossible, around these transactions.
In our last round of analysis, we analyze managerial aversion to external financing. To test this hypothesis, we first model net debt and equity issuances and find that a typical firm raises about 33.5 cents for every dollar of internal cash flow shortfall. However, external financing is reduced by 2.5 cents if a firm raises its charitable contributions from the 50th to the 75th percentile. Furthermore, we find strong managerial aversion to external debt financing. Specifically, modeling a firm’s net debt issuance, we find that a typical firm raises about 94 cents of debt for every dollar increase in its financing deficit. However, debt issuance declines by 3.5 cents if a firm raises its charitable contributions from the 50th to 75th percentile. Given that debt disciplines managers from wasting valuable corporate resources, this finding provides direct evidence supporting Jensen’s (1986) free cash-flow hypothesis. We also show that these effects on external financing are more pronounced in the subsample of firms where managers are protected from the market for corporate control and face weak product market competition.
While the above results are consistent with the existing literature on corporate philanthropy and agency theory, on the surface they stand in stark contrast to the recent literature on corporate social responsibility (CSR), which shows that CSR activities increase firm value. One possibility is that corporate philanthropy has a quite different economic effect from other forms of CSR activities. CSR could be part of a firm’s overall strategy for improving firm value, while corporate giving could be an exception to this strategy where managers create large opportunities for rent extraction. If true, then it follows that conventional measures of CSR could be improved by excluding charitable giving, so as to more accurately represent truly socially responsible activities.
This post comes to us from professors Ronald W. Masulis at the University of New South Wales and Syed Walid Reza at the State University of New York at Binghamton. It is based on their recent article, “Private Benefits and Corporate Investment and Financing Decisions: The Case of Corporate Philanthropy,” available here.