In the paper, R&D and the Incentives from Merger and Acquisition Activity, forthcoming in the Review of Financial Services, my co-author (Alexei Zhdanov of the University of Lausanne and the Swiss Finance Institute) and I examine how the incentives to innovate differ between large and small firms and whether the M&A market hinders or promotes innovative activity. Previous literature has documented that R&D and innovation decreases post-acquisition and has attributed this effect to large firms stifling innovative activity. Using recent data on pre-merger R&D activity, we show that this view is flawed. Rather than large firms stifling R&D by small firms, we show theoretically and empirically how mergers can stimulate R&D activity of small firms. Thus, ex ante R&D rises and then falls naturally after acquisition as the pre-merger stimulus effect wears off.

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In the paper, Multinationals and the High Cash Holdings Puzzle, which was recently made publicly available on SSRN, we investigate whether the cash holdings of American companies are abnormally high after the financial crisis and whether these cash holdings can be explained by the theories summarized in the previous paragraph. We show that the extent to which cash holdings are unusually high after the crisis depends critically on the measure used. We would expect larger firms to hold more cash. Since corporate assets tend to grow over time, the dollar amount of cash holdings would grow even if the ratio of cash to assets stays constant. Consequently, at the very least, cash holdings should be measured relative to a firm’s assets. Using all non-financial and non-regulated public firms with assets and market capitalization greater than $5 million per year, the average cash/assets ratio is 20.18% in 2009-2010 compared to 20.50% in the 2004-2006 pre-crisis period. However, when we consider the median ratio, it is higher by 0.87% in 2009-2010 than in 2004-2006. Similarly, the asset-weighted ratio is higher by 0.74% in the recent period. The larger increase in the asset-weighted ratio than in the equally-weighted ratio suggests that large firms increased their holdings more and we show that this is the case. However, the changes in cash holdings from 2004-2006 to 2009-2010 are dwarfed by the changes in cash holdings from 1998-2000 to 2004-2006. Over that latter period, the average cash/assets ratio increases by 3.77%, the median by 6.39%, and the asset-weighted average by 3.62%. When we distinguish between private and public firms, we show that there is no evidence of an increase in the cash/assets ratio for private firms.

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In our forthcoming Journal of Finance paper, Are Overconfident CEOs Better Innovators?, we find that over the 1993 to 2003 period, CEO overconfidence is associated with riskier projects, greater investment in innovation, and greater innovation as measured by the number of patent applications and patent citations even after controlling for the amount of R&D expenditures. In other words, the R&D investments of overconfident CEOs are more productive in generating innovation. However, greater innovative output of overconfident managers is achieved only in innovative industries. We also find evidence that overconfident CEOs are more effective at exploiting growth opportunities and translating them into firm value, especially within innovative industries. We find that overconfidence remains a strong and significant predictor of innovation even when we remove managers with short tenures at their firms, which suggests that the endogenous hiring of overconfident managers by innovative firms is not the main driver of our findings.

The results of this study have a bearing on the usual presumption that overconfidence is undesirable. Business commentators often point to examples of headstrong, overconfident CEOs who made disastrous decisions. However, the chance of a big defeat may be a corollary to the chance of great victory, so the lesson to draw from examples is unclear. A more serious charge is provided by the evidence of Malmendier and Tate (2008) that the market reacts more negatively to acquisitions made by overconfident CEOs. This dark side to CEO overconfidence might seem to suggest that the CEO selection process should be designed to filter out oversized egos, or that compensation and governance should be designed to severely constrain such CEOs.

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In the paper, Narrative Disclosure and Earnings Performance: Evidence from R&D Disclosures, which was recently made publicly available on SSRN, I examine whether earnings performance relates to the quantity of narrative R&D disclosure that firms provide concurrently in their financial reports. A large body of research examines how managers’ incentives to voluntarily disclose information depend on whether that specific disclosure would reveal good or bad news. This study differs from prior work on the relation between performance and disclosure in that I examine whether earnings performance, a mandatory disclosure, relates to firms’ decisions to provide narrative disclosures – one of the main channels used to convey contextual information about a firm’s operations to investors. While more quantitative disclosures such as earnings guidance have received considerably more attention, narrative information makes up a comparatively large amount of disclosure information and helps to bridge the gap between a firm’s economic reality and its financial statements.

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In my paper, Managerial Investment and Changes in GAAP: An Internal Consequence of External Reporting, which was recently made publicly available on SSRN, I investigate whether changes in Generally Accepted Accounting Principles (GAAP) affect corporate investment decisions. I hypothesize that the relation between changes in GAAP and investment manifests for at least two non-mutually exclusive reasons. First, I hypothesize that changes in GAAP can affect investment because the numbers reported in financial statements have a direct bearing on contractual outcomes. For example, debt contracts often contain covenants based on numbers reported in financial statements (Leftwich [1983]). Consequently, if a change in GAAP has an unfavorable (favorable) impact on current and future financial statements, and debt covenants are not adjusted to incorporate the changes, the change in GAAP will likely tighten (loosen) covenant slack. As a result, managers may alter their actions to avoid covenant violation. Specifically, since most investments have an uncertain future outcome and some positive probability that the outcome is a loss, they increase the probability of violating covenants in the future by adversely impacting future financial ratios. Consequently, managers might respond to changes in GAAP that adversely affect financial statements by cutting investment in risky assets with the goal of preserving net worth and preventing deterioration of financial ratios.

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In our paper, Executive Compensation and Research & Development Intensity, which was recently made publicly available on SSRN, we examine the mediating effect of R&D intensity on the weights on signals of ability and financial performance measures in executive compensation contracts. There are many prior studies that investigate the impact of R&D intensity on total executive compensation (e.g., Dechow and Sloan 1991; Kwon and Yin 2006; Cheng 2004). However, prior studies did not incorporate adverse selection in their analysis. In other words, they did not investigate how R&D intensity affects the role of managerial ability in executive compensation. In contrast, we investigate how R&D intensity impacts the weights placed on human capital measures such as technical work experience, science and engineering degrees, and past experience in R&D intensive firms.

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In the paper, Corporate Governance and Innovation, which was recently made publicly available on SSRN, we examine the effect of corporate governance on innovation as measured by firm research and development (R&D) expenditures. Two different perspectives dominate the academic literature on corporate governance. One perspective emphasizes principal-agent problems and suggests that executives who are protected from shareholder pressure become entrenched. Entrenched executives pursue their own interests at the expense of shareholders. If executives prefer less-risky corporate strategies then an entrenched executive might reduce risky R&D expenditures. An alternative perspective emphasizes that the threat of takeovers forces executives to focus on short-term results so long-term investments such as R&D may suffer. An executive concerned about a takeover threat may reduce R&D expenditures, which are not expensed, to increase short-term profits and stock prices to discourage a hostile takeover. This perspective suggests that entrenched executives who are free from the pressure of hostile takeovers may pursue more R&D expenditures.

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