Shark repellents and research and development

9 SHARK REPELLENTS AND RESEARCH AND DEVELOPMENT: DOES MANAGEMENT HAVE A LONG-RUN PERSPECTIVE?

One of the most difficult challenges faced by tech stock investors is the need to ensure that management maintains an appropriate long-term perspective. In a well-functioning high-tech environment, management pursues those investment projects that promise stockholders the largest payoff when dollars are measured in risk-adjusted net present-value terms. At times, the most meritorious high-tech investment projects involve chancy research and development (R&D) investments that take months, if not years, to bring to fruition. R&D is, at best, a risky bet that can be lost if management abandons basic research projects with significant longterm potential in favor of development projects that promise only modest but near-term benefits. If management lessens its focus on worthy R&D projects because of a myopic concern with near-term results, shareholder results and economic performance both suffer. To provide interesting perspective concerning the effects of important management decisions on R&D, this chapter reports evidence discovered by Hirschey and Jones (1995) concerning firm performance and financial policy decisions in the periods prior to and following corporate adoptions of antitakeover charter amendments, often called shark repellents. Firm performance is examined in terms of the accounting cash flow margin on sales, cash flow return on assets, and total asset turnover and in terms of the market-based total return to shareholders.

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Financial policy is evaluated using the ratio of capital spending to the market value of assets, R&D expenditures relative to the market value of assets, the dividend payout ratio, and leverage as measured by the debt-equity ratio. Estimation results indicate that shark repellent-adopting firms generally have long-term performance that exceeds industry norms during both pre- and postadoption periods. Similarly, shark repellent-adopting firms are generally characterized by financial policies that are compatible with the long-term interests of shareholders during both pre- and postadoption periods. These findings are inconsistent with the notion that shark repellents are adopted to enhance the job security of inefficient or otherwise self-interested management at the expense of shareholders. Instead, these findings are compatible with the hypothesis that shark repellents are adopted by above-average firms that pursue unusually longterm or risky investment projects and, as suggested by Stein (1988), can be consistent with the long-run interests of shareholders.

I. SHARK REPELLENTS Stock market evidence is mixed concerning the economic consequences of corporate charter amendments that invoke antitakeover restrictions, commonly called shark repellents.1 These equivocal results stem from the fact that studies by Brickley, Coles, and Terry (1994), Malatesta and Walking (1988), and Ryngaert (1988), among others, find that the adoption of shark repellents conveys at least two different pieces of information to the marketplace. Shark repellent adoption may be construed as unfavorable evidence that company management is inclined to oppose takeover bids. This explains early documented evidence of a negative stock market reaction to shark repellents over certain samples and time periods (e.g., Jarrell and Poulsen, 1987). On the other hand, shark repellent adoption is favorable evidence that company management has reason to believe that a takeover offer is either likely or imminent. Despite the fact that shark repellents are designed to discourage takeover interest, stock market evidence indicates that the probability of receiving a takeover offer is high for shark repellent-adopting firms and that this higher probability of takeover is sometimes reflected in a positive overall stock-price reaction (Linn and McConnell, 1983; McWilliams 1990). Given the conflicting nature of potential information effects, it is perhaps unsurprising that Brickley, Coles, and Terry (1994) and Ryngaert (1988), among others, report that the average cumulative abnormal return associated with shark repellent adoption is only slightly negative and statistically insignificant. 1Corporate bylaws have been rewritten in at least 41 states to limit or otherwise control corporate takeovers. Almost all such laws involve more than a single antitakeover mechanism, such as regulations on nonstockholder/nonmonetary considerations, limits on business combination/freeze-out provisions, fair price requirements, poison-pill prohibitions, anti-greenmail stipulations, compensation restrictions, and so on. See Mergers & Acquisitions 29 (September/October 1994), 52–53.

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Thus, even though shark repellent adoption has the clear potential to discourage takeover bids and entrench inefficient management (see Pound, 1987), conflicting stock market evidence implies the need to examine more closely the economic characteristics of shark repellent-adopting firms. For example, Brickley, Coles, and Terry (1994) discovered that the stock market reaction to shark repellent announcements was positive for firms with a majority of outside directors, and negative otherwise. Brickley, Coles, and Terry (1994) concluded that at least some shark repellent adoptions can be beneficial and that outside directors serve shareholder interests. Evidence concerning the economic motivation for shark repellent adoptions can be gained by considering the long-term performance and financial policy characteristics of shark repellent-adopting firms in the pre-adoption period. According to the management-entrenchment hypothesis, shark repellents are adopted to enhance the job security of inefficient or otherwise self-interested management at the expense of shareholders (see Mahoney and Mahoney, 1993). If the management-entrenchment hypothesis holds, inferior long-term performance and financial policy decisions would be observed for shark repellentadopting firms in the pre-adoption period. An alternative shareholder-interest hypothesis posits that shark repellents are adopted by above-average firms that pursue unusually long-term or risky investment projects. If shareholders are imperfectly informed, temporarily low earnings may cause a company to become temporarily undervalued in the stock market, thereby increasing the probability of a takeover at an unfavorable price (see Stein, 1988). The extent of such a problem depends on a variety of factors, including the attitudes and beliefs of shareholders, the degree to which corporate raiders have inside information, and the degree to which managers are concerned with keeping control of their firms. If the shareholder-interest hypothesis holds, superior long-term performance and financial policy decisions should be observed for shark repellent-adopting firms in the pre-adoption period. The shareholder-interest hypothesis would also explain why Pound (1989) finds that countersolicitations against management antitakeover proposals are relatively rare. This chapter also reports evidence on the economic implications of shark repellent adoptions by considering the long-term performance and financial policy decisions of shark repellent-adopting firms in the postadoption period. According to the management-entrenchment hypothesis, shark repellents exacerbate, rather than mitigate, any shareholder or managerial myopia concerning the value of unusually long-term or risky investments. In support of the managemententrenchment hypothesis, and contrary to Stein’s (1988) prediction, Meulbroek et al. (1990) found a decrease in the percentage of sales revenue devoted to R&D following the implementation of antitakeover amendments. A reduction in relative R&D spending is consistent with the notion that shark repellents entrench inefficient management and is compatible with stock market evidence that defensive measures have the potential to harm target shareholders. If the managemententrenchment hypothesis holds, inferior long-term performance and financial

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policy decisions should continue to be observed for shark repellent-adopting firms in the postadoption period (see Hirschey and Jones, 1995). If the alternative shareholder-interest hypothesis is relevant, one might expect a continuation of superior long-term performance and financial policy decisions for shark repellent-adopting firms during the postadoption period. For example, in contrast with Meulbroek et al. (1990), Pugh, Page, and Jahera (1992) found a significant increase in capital spending relative to sales, capital spending relative to assets, R&D relative to sales, and R&D relative to assets in the postadoption period. In all instances, changes in financial policy are evaluated in terms of changes in each respective investment ratio over the two-year period surrounding the shark repellent adoption period. Pugh, Page, and Jahera (1992) also look at industry-adjusted ratios and conclude that managers are able to adopt a more effective long-term investment strategy in the postadoption period. More recently, Bhagat and Jefferis (1994) found that the performance of firms that pay greenmail is no worse than the performance of similar-size firms that operate in the same industry, either prior to or following the share repurchase decision. Finally, it is worth noting that the managerial-entrenchment hypothesis presumes that shark repellents are adopted as an effective means for takeover prevention and not as a negotiating ploy in the normal give-and-take between bidders and targets (see Harris, 1990; Hirschey, 1986). While Pound (1987) reports that the probability of takeover does, in fact, decrease following shark repellent adoptions, McWilliams (1990) suggests that firms with low managerial ownership use shark repellents to increase their bargaining power. Since Linn and McConnell (1983) and McWilliams (1990) found positive and statistically significant poison-pill announcement effects, the favorable share-price influence tied to an increase in managerial bargaining power can sometimes more than offset any negative share-price influence resulting from the decreased probability of takeover.

II. DATA Jarrell and Poulsen (1987) study a sample of n = 649 firms adopting shark repellents over the 1979–85 period as obtained from Drexel Burnham Lambert, Kidder Peabody, and the Security and Exchange Commission (SEC) Office of Tender Offers. In Appendix A of their article, Jarrell and Poulsen (1987) list their sample of shark repellent-adopting firms, the proxy signing date, inside ownership, institutional ownership, and amendment type. To estimate the market model for their event study, they require at least 50 trading days in a 150-day estimation period. Using the Investment Statistical Listing (ISL) tapes from Interactive Data Services, Inc., they are able to obtain sufficient data to estimate market-model regressions for 551 out of 649 firms. Given the availability of reliable data over meaningful pre- and postadoption periods, the Jarrell and Poulsen (1987) sample constitutes an attractive basis for

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this examination of the long-term performance and financial policy implications of shark repellent adoptions. Therefore, this study follows Hirschey and Jones (1995) in adopting the Jarrell and Poulsen (1987) sample for analysis. To ensure comparability with previous and subsequent research, this study relies upon widely available Compustat data in the calculation of firm performance and financial policy decision variables. This results in some modest information loss, since only 505 of Jarrell and Poulsen’s (1987) 551 firms have sufficient data available on Compustat. Nevertheless, with 91.6% coverage of the Jarrell and Poulsen (1987) sample, the n = 505 sample studied here is sufficiently broad to offer interesting evidence on the long-term implications of shark repellent adoptions.

III. LONG-TERM PERFORMANCE AND FINANCIAL POLICIES To provide broad-based evidence on the economic implications of shark repellent adoptions, it is worth considering alternative indicators of firm performance and financial policy decisions in the period surrounding shark repellent adoption decisions. As in Healy, Palepu, and Ruback (1992), firm performance is evaluated using a variety of accounting ratios, including the cash flow margin on sales (cash flow/sales), cash flow return on assets (cash flow/assets), and the total asset turnover (sales/assets) ratio. The cash flow margin on sales and the cash flow return on assets measure the firm’s profit-making performance. Higher ratios are consistent with superior performance and are a favorable indication of the firm’s future growth prospects. These cash flow-based measures of firm performance may be superior to more traditional accounting measures, such as the return on shareholders’ equity, because they “look through” the effects of differing assumptions regarding depreciation and other noncash expenses. In addition to being relatively unaffected by accrual accounting conventions, these cash flow-based measures of firm performance are invariant to capital structure decisions. Total asset turnover reflects the firm’s wise use of assets in terms of its ability to generate a high level of sales. The higher the total asset turnover ratio, the more efficient the firm is in its use of assets. Beyond such accounting-based measures of firm performance, it is interesting to consider a market-based indicator of firm performance in the pre- and postadoption periods. The total return to shareholders, including both capital gains and dividends, is a useful indicator of long-term performance in the preand postadoption periods. As such, it has the potential to shed meaningful light on the economic motivation for and implications of shark repellent adoptions. The relationship between shark repellent adoptions and the firm’s investment policy, dividend policy, and capital structure decisions is also evaluated using a variety of measures. Managerial myopia and the management-entrenchment hypothesis is most relevant to the extent that shark repellent-adopting firms can be characterized by relatively low levels of capital spending and R&D investment in the pre- and postadoption periods. The shareholder-interest hypothesis is most

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relevant to the extent that shark repellent-adopting firms can be characterized by relatively high levels of capital spending and R&D investment. The potential relevance of dividend policy and capital structure decisions is suggested by Jensen’s (1986) free cash flow hypothesis, which recognizes high dividend payout ratios and high debt-to-equity (leverage) ratios as effective means for controlling the agency costs of free cash flow. If the self-interested management of shark repellent-adopting firms is typically insulated from market discipline, a significant amount of slack should be observed in these commonly employed corporate control mechanisms. Thus, the managerial-entrenchment hypothesis would predict relatively low dividend payout ratios and low leverage for shark repellent-adopting firms during the pre- and postadoption periods. Conversely, if shark repellents are adopted by firms with managers who are highly motivated to maximize shareholder value, high dividend payout ratios and high leverage should be typical. It follows that effective constraints on the agency costs of free cash flow during the pre- and postadoption periods are consistent with the competing shareholder-interest hypothesis. By considering the link between shark repellent adoptions, investment policy, dividend policy, and leverage during the pre- and postadoption periods, it becomes possible to arrive at some discriminating evidence concerning the predictive capability of the management-entrenchment and shareholder-interest hypotheses.

IV. MEASURES OF LONG-TERM PERFORMANCE AND FINANCIAL POLICIES The cash flow margin on sales reflects the ability of the firm to generate a profit contribution on each dollar of sales revenue. Following Healy, Palepu, and Ruback (1992), the cash flow margin on sales (CFMSt) employed in this study is CFMSt =

CFt , SALESt

(9.1)

where CFt is cash flow defined as net income plus depreciation.2 This cash flowbased measure of profitability is used rather than a more traditional approach in order to minimize the influences of accrual accounting conventions and firm-byfirm differences in accounting policy choice decisions. Whereas a high cash flow margin indicates a commensurately high rate of operating efficiency, a low cash flow margin on sales can reflect the fact that expenses are out of control. Of course, the cash flow margin on sales is related to the effectiveness of the firm’s operating policies and to the vigor of industry competition.

2From

Compustat, INC_DEP (Compustat item #13) is used for income before depreciation, and DEPREC (Compustat item #14) is used for depreciation.

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211

The cash flow return on assets demonstrates how effective the firm is in employing its assets. Not only does the cash flow return on assets indicate whether or not the firm is able to generate profits on assets already in place, it also offers a suggestion of the firm’s future growth prospects. Following Healy, Palepu, and Ruback (1992), the cash flow return on assets (CFMVt) is defined as CFMVt =

CFt . MVt −1

(9.2)

Again, to minimize measurement problems, market values rather than accounting book values of assets in place at the end of the prior year are employed. Total asset turnover reflects the firm’s ability to generate sales relative to the firm’s asset base. Higher ratios indicate a relatively efficient use of assets when the total asset turnover (TATt) ratio is defined as TATt =

SALESt , MVt −1

(9.3)

and MVt−1 is market value defined as total liabilities, plus the book value of preferred, plus the market value of common equity for the year prior to the shark repellent adoption period. The market value of common equity is calculated as the common stock price at the beginning of the year times the number of shares outstanding.3 Like in Healy, Palepu, and Ruback (1992), the market value of the firm is used rather than the more traditional book value of assets in the calculation of the total asset turnover ratio. This approach is designed to minimize the effects of differences in accounting policy choice decisions among firms. In addition to these accounting-based measures of firm performance in the pre- and postadoption periods, it is worth considering performance measures more directly tied to shareholder returns. A simple market-based performance measure is the total stock price plus dividend return (TRt) defined as TRt =

Pt − Pt −1 + Dt , Pt −1

(9.4)

where Pt is the closing price for year t, Pt−1 is the prior-year closing price, and Dt is the dividend paid in year t. TRt is an attractive measure of the total (capital gains plus dividend) return earned by long-term shareholders.

3From

Compustat, LIABTOT (Compustat item #181) is used for total liabilities, and PS_CVAL (Compustat item #130) is used for the book value of preferred stock. AD_CLOSE (same as closing price, CLOS_PR, Compustat item #24, after adjusting for stock splits and dividends) is used for the closing stock price at the end of the year, and ADJ_TRAD (same as common shares traded, CS_TRADE, Compustat item #28, after adjusting for stock splits an dividends) is used for the number of shares outstanding.

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If firms that adopt shark repellents are typical of underperforming targets in the market for corporate control, accounting and market-based performance measures will be inferior to that of industry rivals during the pre-adoption period. If managerial efficiency changes following shark repellent adoptions, relative firm performance will change significantly during the postadoption period.

V. NONPARAMETRIC TESTS OF RELATIVE PERFORMANCE When using either cash flow-based or market-based measures of firm performance, or a variety of indicators of the firm’s financial policy, it is important to recognize the importance of industry-related considerations. Accounting performance, market-based performance, and measures of financial policy are all sensitive to the structure of production, the vigor of industry competition, regulatory climate, and so on. As a result, it is appropriate to measure changes in firm performance and financial policy in the pre- and postadoption periods from within the context of industry norms. Following Healy, Palepu, and Ruback (1992), firm performance and financial policy information are collected from Compustat for each sample observation and for major competitors drawn from each sample observation’s two-digit Standard Industrial Classification (SIC) code industry. Firm performance and financial policy ratios are then computed for each sample observation and for each sample observation’s main competitors. Industry norms are then defined in terms of the median firm performance and financial policy ratios identified for each sample observation’s main competitors. Industry median rather than industry average ratios are employed as descriptive of industry norms because the distribution of firm performance and financial policy ratios is unknown. Use of industry medians rather than industry averages also reduces the potential for bias due to the excessive influence of extreme outliers. To test for differences in firm performance and financial policy decisions for shark repellent-adopting firms, each relevant ratio is compared to the median ratio of the firm’s two-digit SIC industry. Industry-adjusted firm performance and financial policy are measured by each sample observation’s ratio minus the relevant industry median ratio (IARit): IARit = Rit − IRit ,

(9.5)

where IARit is the industry-adjusted firm performance or financial policy ratio for firm i during period t, Rit is the relevant firm ratio, and IRit is the relevant median industry ratio. In these calculations, it is important to keep in mind that each sample observation is excluded from the determination of industry norms. Median firm performance and financial policy ratios, and median industryadjusted ratios, are computed for all sample observations for each of the 5 years prior to the poison-pill-adoption period and for each of the 5 years in the postadoption

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213

period. Again, medians are employed rather than sample averages to minimize the influence of extreme observations. Median firm performance and financial policy ratios are defined for each sample period t: Median Rt = Median ( Rit ,…, Rnt ),

(9.6)

where n is the number of sample observations. Median industry-adjusted firm performance and financial policy ratios are defined for each sample t: Median IARt = Median ( IARit ,…, IARnt ).

(9.7)

Since the sample distribution is unknown, a nonparametric test statistic is an attractive method for evaluating these industry-adjusted ratios. As in Healy, Palepu, and Ruback (1992), a Wilcoxon signed rank test is employed to test whether or not the median industry-adjusted performance and financial policy ratios are statistically different from zero. In this technique, sample observations are sorted from smallest to largest industry-adjusted ratios. Each observation is then assigned a rank, ri, with the smallest ratio being assigned a rank of 1, the second smallest a rank of 2, and so on. If the value of the industry-adjusted ratio is less than zero, it is given a sign indicator, zi, of zero. If the value of the industryadjusted ratio is greater than zero, then zi equals one. The test statistic, w, is w = ∑ zi ri .

(9.8)

To test the statistical significance of wi, the null hypothesis is that the industry-adjusted ratio in question is not significantly different from zero. In this hypothesis test, r+ is the number of industry-adjusted ratios greater than zero over the entire sample of poison-pill-adopting firms, r − is the number of industryadjusted ratios less than zero, and r is the smaller of these two numbers. The null hypothesis can be rejected at the α = 5% level if r is greater than w0.975 or less than w0.025, where w represents the tails of the Wilcoxon and values for w can be found in a table of the critical values for the Wilcoxon signed rank test (see Pfaffenberger and Patterson, 1987). The 5-year median firm performance and financial policy ratios are calculated for years t = −5 to t = −1, and for years t = +1 to t = +5. Then, the median for each ratio over each time frame is calculated. For example, the median ratio for each firm for the t = −5 to t = −1 is calculated as Median Ri = Median ( Ri, −5 ,…, Ri, −1 ).

(9.9)

Median ratios for all poison-pill-adopting firms over the t = −5 to t = −1 period are Median Rt =−5 to −1 = Median [( Median R1 ),…,( Median Rn )]. Identical statistics are also derived over the t = +1 to t = +5 period.

(9.10)

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The median industry-adjusted ratio is found for each firm for years t = −1 to t = −5 by first finding the industry-adjusted ratio for each year and each firm as seen in Eq. (9.7).Then, the industry-adjusted median for years t = −1 to t = −5 for each firm is found as Median IARi = Median [( Median IARi, −5 ),…,( Median IARi, −1 )]. (9.11) The industry-adjusted median performance and financial policy ratios across all firms are found as Median IARt =−5 to −1 = Median [( Median IAR1, ),…,( Median IARn )].

(9.12)

As before, identical statistics are also derived over the t = +1 to t = +5 period. As described previously, a Wilcoxon signed rank test is conducted to test whether or not the industry-adjusted 5-year medians are significantly different from zero.

VI. NONPARAMETRIC RESULTS FOR INDUSTRY-ADJUSTED PERFORMANCE Tables 9.1 and 9.2 show that industry-adjusted firm performance measures are generally superior in the pre- and postadoption periods for shark repellentadopting firms. Industry-adjusted firm performance is superior and statistically significant for shark repellent-adopting firms in the preadoption period for all four measures of relative firm performance. In three of four instances, industryadjusted firm performance is also superior and statistically significant for shark repellent-adopting firms in the postadoption period. In Table 9.1, the cash flow margin on sales for adopting firms is uniformly better than that earned by competitors in both the pre- and postadoption periods. In fact, adopting firms have a greater cash flow margin on sales than their industry counterparts in each subperiod analyzed. In the 5 years prior to shark repellent adoption, the median cash flow margin on sales for adopting firms is 15.39%. Moreover, adopting firms display a median cash flow margin on sales that is 1.89% greater than the median performance of industry competitors. In the 5-year postadoption period, the median cash flow margin on sales for adopting firms is roughly the same at 15.53% and displays a similar performance margin of 2.21% over industry competitors. In both periods, roughly three-fifths of shark repellent-adopting firms generate cash flow margin on sales performance that is superior to industry competitors. Table 9.1 also shows that the median cash flow return on assets earned by adopting firms is 27.72% in the pre-adoption period and 19.42% in the postadoption period. As in the case of the cash flow margin on sales, the cash flow return on assets for adopting firms is uniformly better than that earned by competitors in the pre- and postadoption periods. The pre-adoption period

TABLE 9.1

Cash Flows are Relatively High for Shark Repellent-Adopting Firms Cash flow margin on sales (CFMS)

Year

Median (%)

Industryadjusted median (%)b

−5 −4 −3 −2 −1 −5 to −5 1 2 3 4 5 1 to 5

16.14 15.27 15.17 15.04 15.20 15.39 15.43 15.35 15.61 16.06 15.61 15.53

1.70 1.84 1.98 2.14 2.09 1.89 2.39 1.63 1.78 2.72 2.54 2.21

Cash flow return on assets (CFMV)

Percent positive (%)b

n

63.7 63.0 64.4 63.6 62.2 64.8 62.2 59.5 61.5 62.7 65.5 62.6

438 449 458 464 468 469 445 425 405 381 371 447

Median (%)

Industryadjusted median (%)b

Percent positive (%)b

n

34.76 30.76 27.95 25.97 25.06 27.72 21.51 20.59 18.51 18.94 19.40 19.42

2.84 2.87 3.89 3.34 3.08 2.68 1.90 1.58 1.38 1.96 2.46 1.73

59.0 60.9 61.4 62.8 63.2 63.6 59.8 58.7 57.6 59.5 60.9 60.1

405 417 435 449 457 459 443 424 403 375 363 446

IACFMSpost = 0.029 + 0.289IACFMSpre (5.09)b (35.97)b

IACFMVpost= 0.027 + 0.145IACFMVpre (5.49)b (7.13)b

R2 = 62.48% F = 776.01b

R2 = 10.48% F = 50.82b

n = 467

n = 435

Note: The industry-adjusted median cash flow margin on sales (CFMS) and cash flow return on assets (CFMV) are both relatively high for shark repellentadopting firms in the 5-year pre- and postadoption periods. Statistically significant intercept coefficients from a simple regression of postadoption industryadjusted medians on preadoption levels indicate statistically significant increases in both CFMS and CFMV between the pre- and postadoption periods for shark repellent-adopting firms. t-statistics are in parentheses. IACFMS is the industry-adjusted cash flow margin on sales. IACFMV is the industry-adjusted cash flow return on assets. a Significant with 95% confidence (α = 5%). b Significant with 99% confidence (α = 1%).

TABLE 9.2

High Total Asset Turnover and Superior Total Returns are Evident for Shark-Repellent Adopting Firms Total asset turnover (TAT)

Total return (TR)

Percent positive (%)b

n

Median (%)

Industryadjusted median (%)b

Percent positive (%)b

n

49.5 53.1 52.8 51.2 52.9 51.3 50.0 47.3 47.8 49.3 47.7 50.5

434 448 466 484 493 495 474 455 431 404 390 477

18.25 20.29 13.84 18.06 21.19 19.13 10.03 11.90 7.95 11.05 9.33 11.26

0.50b 5.16b 1.76b 4.61b 7.75b 4.35b 4.86b 4.52a 4.59b 6.15b 4.97b 5.75b

50.6 57.2b 52.9 57.9b 60.6b 61.9b 55.4a 57.6b 55.9a 60.9b 59.9b 64.6b

441 451 467 487 498 499 478 460 433 414 387 480

Year

Median (%)

Industryadjusted median (%)b

−5 −4 −3 −2 −1 −5 to −1 1 2 3 4 5 1 to 5

214.86 205.32 186.75 170.88 152.68 180.70 129.94 121.46 105.17 105.71 105.56 115.22

−0.35 1.45b 0.92a 0.98b 1.54b 0.26a −0.10 −1.32 −0.81 −0.25 −1.19 0.15

IATATpost = −0.001 + 0.593IATATpre (−0.02) (27.86)b

IATRpost = 0.062 − 0.011IATRpre (6.21)b (−0.43)

R2 = 74.49% F = 1293.76b n = 444

R2 = 0.04% F = 0.18

n = 472

Note: Relatively high industry-adjusted median total asset turnover (TAT) is characteristic of shark repellent-adopting firms during the 5-year preadoption period; TAT is typical of industry norms in the postadoption period. Superior total returns (TR) to shareholders (dividends plus capital gains) are evident for shark repellent-adopting firms in both the 5-year pre- and postadoption periods. The intercept coefficient from a simple regression of postadoption industryadjusted medians on preadoption levels indicate a statistically significant favorable increase in TR between the pre- and postadoption periods. t-statistics are in parentheses. IATAT is the industry-adjusted total asset turnover. IATR is the industry-adjusted total return to shareholders. a Significant with 95% confidence (α = 5%). b Significant with 99% confidence (α = 1%).

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217

industry-adjusted median cash flow return on assets is 2.68% higher for adopting firms than for their industry counterparts; it is 1.73% higher than industry competitors during the postadoption period. Also, as in the case of the cash flow margin on sales, roughly three-fifths of shark repellent-adopting firms generate a cash flow return on assets that is superior to industry competitors. In Table 9.2, the industry-adjusted total asset turnover ratio is higher for adopting firms in the period prior to shark repellent adoptions, but not in the postadoption period. The statistically significant industry-adjusted total asset turnover ratio of 0.26% in the pre-adoption period signifies that the median ratio of 180.70% for adopting firms is 0.26% greater than the median total asset turnover ratio for competitors. This signals a relatively wise use of assets by adopting firms in the pre-adoption period in that relatively high amounts of revenue are generated for a fixed level of capital investment. However, there may be some slight deterioration in the asset management performance of adopting firms in the postadoption period. The median total asset turnover ratio of 115.22% for adopting firms in the postadoption period is not statistically different than the median total asset turnover ratio for competitors. Table 9.2 also shows that the median total capital gain plus dividend return earned by shareholders of adopting firms is 19.13% in the pre-adoption period and 11.26% in the postadoption period. As in the case of the cash flow-based performance measures, the total return for adopting firms is uniformly better than that earned by competitors in the pre- and postadoption periods. The pre-adoption period industry-adjusted median total return is 4.35% higher for adopting firms than for their industry counterparts; it is 5.75% higher than industry competitors during the postadoption period. As in the case of the cash flow-based performance measures, roughly three-fifths of shark repellent-adopting firms generate a total return to shareholders that is superior to industry competitors.4 In sum, these nonparametric results for industry-adjusted performance are broadly consistent with the shareholder-interest hypothesis and inconsistent with a management-entrenchment explanation of shark repellent adoptions. As predicted by the shareholder-interest hypothesis, firms that adopt shark repellents can be characterized as superior performers during the pre- and postadoption periods. This may be construed as some evidence that managers use the takeover protection offered by shark repellents to make investments in profitable projects 4A

more comprehensive market-based measure of the total return to equity stakeholders in poison-pill-adopting firms would explicitly incorporate the effects of equity buyback decisions. After adjustment for equity buybacks, superior returns for shareholders of poison-pill-adopting firms remain evident. In the pre-adoption period, the median return to shareholders is 22.08%; in the postadoption period, the median return to shareholders is 14.20%. During both periods, the median return to shareholders of adopting firms is greater than the median return earned by industry competitors. The pre-adoption period industry-adjusted median return to shareholders is 3.97% higher for adopting firms than for their industry counterparts; it is 6.58% higher than industry competitors during the postadoption period. After adjustment for buybacks, roughly three-fifths of adopting firms display superior returns to shareholders over each of the pre- and postadoption periods.

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that are unusually risky or long-term in nature. In any event, it seems fair to characterize shark repellent-adopting firms as relatively good performers when compared against industry counterparts.

VII. MEASURES OF FIRM FINANCIAL POLICY According to the management-entrenchment hypothesis, shark repellents are adopted to enhance the job security of inefficient or otherwise self-interested management (see Mahoney and Mahoney, 1993). Any such failure to adopt optimal performance standards and financial policies is a type of agency problem that arises when slack in the managerial labor market permits managers to pursue value-reducing projects with excess or free cash flow (see Jensen, 1986). Thus, a myopic focus on short-term or low-risk projects and low rates of capital spending and R&D expenditures would be typical if the management-entrenchment hypothesis is descriptive of shark repellent-adopting firms. In a similar vein, notable managerial slack due to relatively low dividend payout ratios or low leverage in the pre- and postadoption periods would be consistent with the management-entrenchment hypothesis. By way of contrast, the shareholder-interest hypothesis suggests that shark repellents might be adopted by above-average firms that pursue unusually longterm or risky investment projects. When shareholders are imperfectly informed, temporarily low earnings could cause a company to become temporarily undervalued in the stock market, thereby increasing the probability of a takeover at an unfavorable price (see Stein, 1988). Accordingly, the shareholder-interest hypothesis predicts relatively high rates of capital spending and R&D expenditures by shark repellent-adopting firms in the pre- and postadoption periods. Similarly, an absence of managerial slack due to relatively high dividend payout ratios or significant leverage in the pre- and postadoption periods would be consistent with the shareholder-interest hypothesis. To examine the possibility of changes in the pace of capital expenditures in the period surrounding shark repellent adoptions, the ratio of capital spending over the market value of assets is also investigated as suggested by Healy, Palepu, and Ruback (1992). The capital spending (CSMVt) ratio is defined as CSMVt =

CAPITAL SPENDINGt . MVt −1

(9.13)

where CAPITAL SPENDINGt is expenditures on fixed capital for the firm, and MVt is the market value of the firm as defined previously.5

5From

Compustat, SC_CAPSP (Compustat item #128) is used for capital spending.

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219

As in Healy, Palepu, and Ruback (1992), spending on R&D relative to the market value of assets is used as a measure of the firm’s rate of spending on “intangible capital” that has the potential to improve the firm’s long-run profit potential. The R&D spending intensity (R&DMVt) ratio is defined as R & DMVt =

R & Dt , MVt −1

(9.14)

where R&Dt is expenditures on R&D, and MVt is as defined beforehand.6 Because the payoff from R&D investment is relatively long-term and risky in nature, changes in the firm’s R&D financial policy have the potential to provide insight concerning any myopic behavior, or changes in myopic behavior, on the part of management. Of particular interest to this study is the extent to which managerial myopia might be induced or changed by shark repellent adoptions. To capture the resource management practices of firms that adopt shark repellents, this study considers the possibility of changes in the dividend payout ratio during the pre- and postadoption periods. The dividend payout ratio (DPRt) is defined as total dividends divided by net income: DPRt =

Dt ⋅ St , NET INCOMEt

(9.15)

where Dt is the annual dividend per share, and St is the number of common shares outstanding.7 As a further indication of the influence of shark repellent adoptions on resource management practices in the pre- and postadoption periods, this study considers the possibility of changes in the firm’s capital structure. Like an increase in the dividend payout ratio, an increase in leverage and required interest payments can have the effect of reducing managerial slack in the deployment of free cash flow. As in Healy, Palepu, and Ruback (1992), any change in leverage in the period surrounding shark repellent adoptions is measured using the debt-equity ratio (DERt) defined as8 DERt =

6From

TOTAL LIABILITIESt . COMMON EQUITYt

(9.16)

Compustat, RD_EXP (Compustat item #46) is used for R&D. Compustat, ADJ_DIV (same as DIV_PS, Compustat item #26, after adjusting for stock splits and dividends) is used for the annual dividend paid per share, and NET_INC (Compustat item #172) is used for net income. 8From Compustat, STHOEQ (Compustat item #216) is used for common equity. 7From

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VIII. NONPARAMETRIC RESULTS FOR INDUSTRY-ADJUSTED FINANCIAL POLICY Nonparametric results for industry-adjusted financial policy decisions are generated using the same methodology as that described for the industry-adjusted analysis of firm performance. Simply put, Table 9.3 offers support for the shareholder-interest hypothesis that shark repellent-adopting firms invest unusually large amounts in long-term or risky investment projects in the pre-adoption period. Table 9.3 offers no support for the management-entrenchment hypothesis that shark repellent-adopting firms underinvest in plant and equipment or R&D in the pre-adoption period. In Table 9.3, the industry-adjusted ratio of capital spending to the market value of the firm is higher for adopting firms in both the pre- and postadoption periods. The statistically significant industry-adjusted capital spending to market value ratio of 1.58% in the pre-adoption period indicates that the median ratio of 11.63% for adopting firms is 1.58% greater than the median capital spending to market value ratio for competitors. This suggests marginally higher plant and equipment investment activity on the part of adopting firms in the pre-adoption period. However, there may be some modest deterioration vis-a-vis competitors in this margin of investment intensity in the postadoption period. The median capital spending to market value ratio of 6.61% for adopting firms in the postadoption period is only 0.32% higher than the industry-adjusted median. Still, the modestly higher ratio of capital spending to the market value of the firm for adopting firms is statistically significant. Table 9.3 also shows that the R&D to market value ratio for adopting firms is generally higher than that of competitors in the pre-adoption period, but not during the postadoption period. In the 5 years prior to shark repellent adoption, the median R&D to market value ratio for adopting firms is 2.75%, or a modest premium of 0.02% above industry norms. In the 5-year postadoption period, the R&D to market value ratio falls slightly to 2.43%, a percentage that is roughly the same as industry competitors. Table 9.4 reports on the dividend policy and capital structure decisions of shark repellent-adopting firms. As predicted by the shareholder-interest hypothesis, shark repellent adoptions appear to be common among firms that display relatively high payouts of dividends (have high free cash flow) and relatively high leverage. Table 9.4 reveals that the median dividend payout ratio by adopting firms is 7.47% in the pre-adoption period and 12.09% in the postadoption period. The pre-adoption period industry-adjusted median payout ratio is 3.50% higher for adopting firms than for their industry counterparts; it is 8.39% higher than industry norms during the postadoption period. In both periods, the industryadjusted median payout ratio is statistically significant. It is also interesting to note that dividend payout ratios exceed industry norms for roughly two-thirds of shark repellent-adopting firms. Table 9.4 also shows that the median debt-toequity ratio for adopting firms is 120.36% in the pre-adoption period and 129.98% in the postadoption period. This pre-adoption period industry-adjusted

TABLE 9. 3

Capital Spending and R&D are High for Shark-Repellent Adopting Firms Capital spending to market value (CSMV)

Year

Median (%)

Industryadjusted median (%)b

−5 −4 −3 −2 −1 −5 to −1 1 2 3 4 5 1 to 5

13.31 12.71 11.94 10.07 9.39 11.63 8.03 6.97 5.98 5.50 5.70 6.61

1.21b 1.72b 1.78b 1.40b 0.79b 1.58b 0.41b 0.31b −0.00 0.00 0.38b 0.32a

R&D to market value (R&DMV)

Percent positive (%)b

n

57.5b 62.2b 60.5b 59.7b 57.9b 60.5b 52.2 51.7 49.2 49.6 53.8 52.7

381 392 408 422 430 433 414 393 372 345 333 421

Median (%)

Industryadjusted median (%)b

Percent positive (%)b

n

2.61 2.89 3.01 3.16 2.86 2.75 2.86 2.74 2.37 2.23 2.43 2.43

0.06b 0.17b 0.09b 0.23b 0.00 0.02b 0.00 0.00 0.00 0.00 0.00 0.00

52.9a 52.0a 53.2a 52.8a 46.8 50.6 44.7 41.8 43.0 39.7 42.5 42.7

221 223 231 235 237 265 228 213 200 184 181 241

IACSMVpost = 0.341 × 10−3 + 0.243IACSMVpre (0.14) (8.36)b

IAR&DMVpost = 0.003 + 0.057IAR&DMVpre (1.63) (4.12)b

R2 = 14.63% F = 69.90b

R2 = 6.92% F = 16.94b n = 229

n = 409

Note: Relatively high industry-adjusted median capital spending to market value (CSMV) and median research and development to market value (R&DMV) are typical for shark repellent-adopting firms in the 5-year preadoption period. CSMV also exceeds industry norms in the postadoption period, whereas the R&DMV of shark repellent-adopting firms is typical of industry counterparts in the postadoption period. Insignificant intercept coefficients that result from a comparison of these two measures over the pre- and postadoption periods suggest no meaningful change due to shark repellent adoption. t-statistics are in parentheses. IACSMV is the industry-adjusted capital spending to market value ratio. IAR&DMV is the industry-adjusted R&D to market value ratio. a Significant with 95% confidence (α = 5%). b Significant with 99% confidence (α = 1%).

TABLE 9.4

Dividend Payout Ratios and Leverage are High for Shark-Repellent Adopting Firms Dividend payout ratio (DPR)

Year

Median (%)

Industryadjusted median (%)b

−5 −4 −3 −2 −1 −5 to −1 1 2 3 4 5 1 to 5

6.40 6.72 7.89 7.95 9.54 7.47 10.02 12.15 12.44 11.02 9.87 12.09

2.18 3.07 3.51 4.22 5.88 3.50 7.12 9.09 8.35 6.72 7.16 8.39

Debt-to-equity ratio (DER)

Percent positive (%)b

n

64.4 64.5 63.3 63.8 65.4 65.1 62.9 62.3 61.5 63.1 63.1 65.0

449 467 485 494 503 504 474 453 426 401 382 475

Median (%)

Industryadjusted median (%)b

Percent positive (%)b

n

120.21 122.43 119.85 119.23 116.72 120.36 128.26 129.98 135.82 142.43 144.97 129.98

3.53a 4.82b 2.92b 7.61b 6.22b 4.21b 12.25b 13.57b 14.71b 12.97b 16.11b 14.91b

51.7 51.8 51.9 55.0a 52.9 52.5 57.0b 59.0b 56.7b 56.8b 59.3b 57.1b

468 479 493 500 505 505 477 458 434 410 398 478

IADPRpost = 0.125 + 0.445IADPRpre (4.50)b (1.92)

IADERpost = 0.276 + 0.482IADERpre (2.59)a (6.24)b

R2 = 0.78% F = 3.69

R2 = 7.58% F = 38.97a

n = 472

n = 476

Note: Relatively high industry-adjusted medians for the dividend payout ratio (DPR) and median debt-to-equity (DER) are typical for shark repellentadopting firms in both the 5-year pre- and postadoption periods. Intercept coefficients from a simple regression of postadoption industry-adjusted medians on preadoption levels indicate a statistically significant favorable increase in both measures between the pre- and postadoption periods. t-statistics are in parentheses. IADPR is the industry-adjusted dividend payout ratio (dividends over net income). IADER is the industry-adjusted debt-to-equity ratio. a Significant with 95% confidence (α = 5%). b Significant with 99% confidence (α = 1%).

REGRESSION MODEL SPECIFICATION

223

median leverage ratio is 4.21% higher for adopting firms than for their industry counterparts; it is 14.91% higher than industry competitors during the postadoption period. During both periods, shark repellent-adopting firms display payout ratios that are significantly higher than those for industry counterparts. In sum, based upon nonparametric results shown in Table 9.3, it is fair to conclude that shark repellent-adopting firms tend to display higher than typical levels of investment in plant and equipment and R&D. Based upon results shown in Table 9.4, it also is fair to deduce that shark repellent-adopting firms display relatively high dividend payout and leverage (debt-to-equity) ratios. None of these findings is consistent with the concept of management entrenchment and the use of shark repellents by managers of firms that underinvest in risky or longterm projects. The fact that shark repellent-adopting firms tend to invest heavily in long-term or risky projects, pay out relatively high amounts of free cash flow, and employ significant leverage is consistent with the shareholder-interest hypothesis. Industry-adjusted medians reported in Tables 9.1–9.4 are interesting because they offer useful insight concerning adopting firm performance and financial policy in the pre- and postadoption periods. For a direct test of changes in firm performance and financial policy resulting from shark repellent adoptions, it is necessary to analyze changes in firm performance and financial policy decisions in the period surrounding shark repellent adoptions.

IX. REGRESSION MODEL SPECIFICATION Following Healy, Palepu, and Ruback (1992), simple cross-sectional regressions are estimated to capture statistical differences between postadoption industryadjusted ratios and corresponding pre-adoption ratios. These simple regression equations take the form IARi, post = α + βIARi, pre + u,

(9.17)

where IARi,post is the median industry-adjusted firm performance or financial policy ratio for the 5-year postadoption period, and IARi,pre is similar median industry-adjusted ratios for the 5-year pre-adoption period as defined in equation. In this simple regression, the estimated slope coefficient, β, captures the correlation between pre- and postadoption firm performance and financial policy decisions. More important is the size and statistical significance of α, the intercept term. The estimated intercept coefficient α is independent of pre-adoption performance and reflects significant changes in the industry-adjusted relative position of adopting versus nonadopting firms in the postadoption period. Using this approach, significant changes in relative firm performance or financial policy decisions in the postadoption period are reflected by statistically significant intercept coefficient estimates.

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X. REGRESSION RESULTS FOR CHANGES IN FIRM PERFORMANCE Tables 9.1 and 9.2 report simple regression results with the potential to shed light on the statistical significance of changes in adopting firm performance between the pre- and postadoption periods. From Table 9.1, some modest increase in the relative cash flow margin on sales can be noted. To see this, notice the statistically significant intercept coefficient of 0.029 in the cash flow margin on sales regression equation. This means that, on average, the industry-adjusted cash flow margin on sales is 0.029% higher for adopting versus nonadopting firms in the postadoption period. Therefore, the relative position of shark repellent-adopting firms improves modestly versus industry counterparts over this time frame. Table 9.1 also shows a statistically significant intercept coefficient estimate of 0.027 in the cash flow return on assets regression. This means that the median industry-adjusted cash flow return on assets is 0.027% higher for shark repellent-adopting firms versus industry counterparts in the postadoption period. In a similar vein, Table 9.2 indicates no change in the relative total asset turnover performance of shark repellent-adopting firms is apparent, but depicts a statistically significant intercept coefficient estimate of 0.062 in the total capital gains plus dividend return regression equation. This implies that the median industry-adjusted total return is 0.062% higher for adopting firms versus industry counterparts in the postadoption period. Taken as a whole, this simple regression analysis of changes in industryadjusted firm performance suggests a pattern of generally improving relative performance for shark repellent-adopting firms over the pre- and postadoption periods. As such, firm performance over the pre- and postadoption periods is inconsistent with the management-entrenchment hypothesis and instead suggests that shark repellent-adopting firms are relatively good performers that act in the interest of shareholders.

XI. REGRESSION RESULTS FOR CHANGES IN FINANCIAL POLICY DECISIONS Tables 9.3 and 9.4 report simple regression results with the potential to shed light on the statistical significance of changes in adopting firm financial policy decisions between the pre- and postadoption periods. In Table 9.3, statistically insignificant intercept coefficients for the capital spending and R&D expenditure regressions suggest no meaningful change in the investment policies of shark repellent-adopting firms over the pre- and postadoption periods. During both periods, adopting firms display relatively high levels of capital spending, while above-average pre-adoption period R&D intensity reverts to industry norms during the postadoption period.

CONCLUSION

225

Table 9.4 shows that the already high dividend payout ratios and debt-toequity (leverage) ratios for adopting firms increase somewhat following the adoption of shark repellents. The statistically significant intercept coefficient estimate of 0.125 in the dividend payout ratio regression means that the median industryadjusted level is 0.125% higher for adopting versus nonadopting firms in the postadoption period. The statistically significant intercept coefficient estimate of 0.276 in the debt-to-equity (leverage) ratio regression means that the median industry-adjusted level is 0.276% higher for adopting versus nonadopting firms in the postadoption period. Again, these ratio increases are noted despite the fact that pre-adoption period payout and leverage ratios exceed industry norms for shark repellent-adopting firms. On an overall basis, steady capital spending and R&D expenditures and higher payout ratios and financial leverage appear to be typical following shark repellent adoption. As such, the financial policies for adopting firms seem quite compatible with the shareholder-interest hypothesis and inconsistent with the management-entrenchment hypothesis.

XII. CONCLUSION Hirschey and Jones (1995) investigates firm performance and financial policy decisions in the period surrounding the adoption of antitakeover corporate charter amendments, commonly referred to as shark repellents. To provide broadbased evidence on the economic implications of shark repellent adoptions, a wide range of accounting-based cash flow measures and market-based measures of firm performance are considered. The implications of shark repellent adoptions for financial policy decisions are also evaluated using a variety of measures. The purpose of this analysis is to test competing management-entrenchment and shareholder-interest hypotheses. The management-entrenchment hypothesis holds that shark repellents are adopted to enhance the job security of inefficient or otherwise self-interested management at the expense of shareholders (see Mahoney and Mahoney, 1993). If the management-entrenchment hypothesis holds, inferior long-term performance and financial policy decisions should be observed for shark repellent-adopting firms in pre- and postadoption periods. An alternative shareholder-interest hypothesis posits that shark repellents are adopted by above-average firms that pursue unusually long-term or risky investment projects. If shareholders are imperfectly informed, temporarily low earnings may cause a company to become temporarily undervalued in the stock market, thereby increasing the probability of a takeover at an unfavorable price (see Stein, 1988). If the shareholder-interest hypothesis holds, superior long-term performance and financial policy decisions should be observed for shark repellent-adopting firms in the pre- and postadoption periods. By considering the implications of shark repellent adoptions for long-term performance and financial policy decisions, it becomes possible to arrive at some discriminating evidence concerning the

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predictive capability of competing management-entrenchment and shareholderinterest explanations of shark repellent adoptions. Nonparametric results suggest uniformly superior long-term performance for shark repellent-adopting firms in the pre-adoption period. This finding undermines the notion that shark repellents are adopted by the self-interested management of poorly performing firms. In the postadoption period, the cash flow margin on sales, the cash flow margin on assets, and the total return to shareholders remain above industry medians, while total asset turnover is consistent with industry norms. In terms of long-term performance, there is no evidence that the long-term performance of poison-pill-adopting firms falls below industry medians during the postadoption period. Nonparametric results also suggest consistently superior investment policy, dividend policy, and leverage decisions for shark repellent-adopting firms in the pre-adoption period. Again, this finding undermines the notion that shark repellents are adopted by the self-interested management of firms that shun unusually long-term or risky investment projects. It is fair to suggest that shark repellentadopting firms display above-normal levels of investment in plant and equipment, dividend payout ratios, and financial leverage in the postadoption period. R&D intensity is also above industry norms in the pre-adoption period for shark repellent-adopting firms. Because R&D intensity is consistent with industry norms in the postadoption period, there is no evidence of a meaningful and systematic underinvestment in R&D activity following shark repellent adoption. None of these findings is consistent with the concept of managerial entrenchment and the use of shark repellents by managers of firms that operate in a nonvaluemaximizing manner. A simple regression analysis of changes in industry-adjusted long-term performance and financial policy decisions over pre- and postadoption periods is consistent with nonparametric results and the shareholder-interest hypothesis. In three of four instances (cash flow margin on sales, cash flow return on assets, and total return to shareholders), the relative improvement in long-term performance for shark repellent-adopting firms is statistically significant. No change in relative total asset turnover is noted in the postadoption period. In two of four instances (dividend payout ratio and leverage), the relative change in financial policy for shark repellent-adopting firms is also statistically significant. Importantly for high-tech investors, no meaningful change in capital spending or R&D expenditures is apparent. Taken as a whole, these findings suggest that shark repellents are adopted by firms with long-term performance that is generally above industry norms during both pre- and postadoption periods. When significant change is noted, long-term performance improves during the postadoption period. Because shark repellentadopting firms also commonly adopt financial policies that are compatible with shareholder interests, it is fair to suggest that there is no necessary conflict between shark repellent adoptions and shareholder interests.

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