Executive Summaries

Financial Management (Financial Management Association), Summer, 1999

CEO Ownership, Leasing, and Debt Financing

Why do corporations lease assets rather than buy them? This question has been the subject of much empirical research. Earlier studies tended to focus on the extent to which leasing and debt are substitute forms of financing or on tax considerations. More recent studies have taken a broader view of financial contracts as a means by which corporations shift risk, alter incentives, and transfer tax liabilities. Under this view, lease financing can alter the benefits and risks of asset use in ways that other financial contracts cannot.

This study also adopts the financial contracting view of lease financing. Our primary contribution is our finding of a strong positive relationship between CEO stock ownership and lease financing. In fact, corporations whose CEOs own larger fractions of the company's stock tend to use more of both conventional debt and lease financing. It is generally agreed that, for most firms, some amount of debt financing can enhance shareholder value. It thus makes sense that CEOs with large ownership stakes in their own companies have stronger incentives to use debt in order to increase shareholder value. Debt financing also makes it easier for these CEOs to maintain their control over the company. At the same time, however, debt exposes a company to financial risk, and thus the personal risk borne by CEOs with large ownership stakes increases with debt. Leasing, on the other hand, allows the company to shift some of this risk. In particular, the risk of obsolescence is shifted to the lessor, since the asset reverts to the lessor at the end of the lease contract. We interpret our empirical findings, then, as evidence that CEOs with large ownership stakes use more lease financing as a means to control their personal risk exposure.

We use a sample of 176 US manufacturing companies, with data taken from the period 1986-91. We use two measures of a company's leasing intensity. The first is the ratio of capitalized lease obligations to total assets. The second is the share of annual leasing expense in annual total capital costs. Our second measure differs from the first in that it incorporates operating leases as well as capitalized leases. This is important because an operating lease, whose term is usually shorter than an asset's useful life, affords greater opportunities for shifting obsolescence risk to the lessor than does a capitalized lease.

We first regress our measures of leasing intensity against CEO ownership and company size, as well as the squares of both variables. We include size to control for the strong negative correlation between company size and CEOs' ownership fractions. We find that, even after correcting for the negative impact of size on leasing financing, CEO ownership exerts an independent and significantly positive influence on both measures of leasing. The squared terms indicate that both ownership and size effects tend to diminish at the margin as CEO ownership and size increase.

We then estimate a more complete model that controls for other possible influences on the use of lease financing. In addition, we estimate an equation to explain companies' use of conventional debt financing, and we test for interactions between lease financing and debt. We find that CEO ownership continues to exert a significant positive influence on leasing activity. We also find that firm size is positively related to debt financing, as financial contracting theory predicts, but it is now also positively related to the share of lease payments in total capital costs. We find only weak evidence in support of investment-opportunity-set and tax effects on leasing. Other studies that have found stronger evidence of these effects have used larger samples, so the size of our sample may be insufficient to identify these effects clearly. Finally, we find evidence of a positive interaction between debt and leasing only for capitalized leases; when the lease variable includes operating leases, we find no significant interaction.

Hamid Mehran, Robert A. Taggart, and David Yermack

Tax Options, Clienteles, and Adverse Selection: The Case of Convertible Exchangeable Preferred Stock

Investors in convertible preferred stock have the option to convert the preferred into common stock. Convertible exchangeable preferred stock works the same way, but adds an option for the issuing firm to exchange the preferred shares for convertible bonds in the future. An exchange must preserve the conversion terms, and the coupon rate on the new bond must match the preferred dividend rate that it replaces.

A firm that raises capital using convertible preferred stock may find itself able to benefit from the tax deductibility of convertible debt interest in the future. Convertible exchangeable preferred lets the firm obtain additional tax deductions when it can use them, free of additional underwriting costs. This tax-timing option is valuable to an issuing firm that is in a low tax bracket when it raises capital but may face higher tax rates in the future. However, an exchange can be detrimental to investors. Corporate investors exclude the majority of a cash dividend (currently 70%) from their taxable income. An exchange would force such an investor either to endure a reduction in after-tax income or to incur the expense of selling the securities and reinvesting its funds. Thus, a potential reason for avoiding exchangeable convertible preferred is if the firm has or can attract an investor clientele that seeks stable preferred dividends. The firm can gain from serving the clientele if the investors are willing to accept a reduced yield (on non-exchangeable convertible preferred stock) in return for stability, or if being able to come back to the clientele for future offerings reduces the firm's financing costs.