Two essays on corporate activities and the market for corporate control

Abstract

This dissertation addresses concerns regarding corporate activities in relation to agency costs and studies the effect of the market for corporate control. In the first essay, we use the mid-1990s Delaware takeover regime shift as an exogenous shock to examine how the removal of takeover threats affects managerial decisions on corporate financing and investment and how it affects firm value. Based on a differences-in-differences-in-differences (DDD) approach, we find that managers reduce debt financing and increase capital investment when they are protected against hostile takeovers, which is consistent with managerial agency models of capital structure and the free cash flow hypothesis proposed by Jensen (1986). We demonstrate that engaging in these entrenched behaviors consequently destroys firm value. Moreover, our evidence indicates that the effect of the takeover regime shift is more pronounced in firms with fewer institutional holdings or lower managerial ownership, supporting the argument of Jensen (1993) that effective internal control systems can alleviate the negative outcomes of a weakened market for corporate control. The substitution effect of internal controls is more substantial than that of the external product market competition. Finally, we determine that empire building, rather than quiet life, is the main consequence of a weakened market for corporate control.

In the second essay, we directly examine the causal relationship between managerial entrenchment and diversification. We demonstrate that more entrenched managers adopt higher levels of diversification than do less entrenched managers. We verify the result by using two-stage least squares (2SLS) regression and treating entrenchment as endogenous. In addition, based on an exogenous change in takeover legislation in Delaware in the mid-1990s, we adopt the differences-in-differences-in-differences (DDD) approach and demonstrate that managers increase diversification activities when they are protected against hostile takeovers. Given that diversification destroys value, these results are consistent with the agency costs explanation of diversification. We then explore the motivations that drive managers to diversify. We document that entrenched managers diversify to gain private benefits and to reduce firm risk. Finally, we demonstrate that CEO equity-based incentives increase when takeover-protected firms diversify, suggesting that firms proactively respond to counterbalance the increased costs associated with discretional diversification, which is consistent with theories of optimal contract.