RSS feed for
News Items

STANFORD GRADUATE SCHOOL OF BUSINESS — In 2006, spinach producers were hit by an outbreak of E. coli contamination that ground the industry to a halt as all spinach-based food products were yanked from the U.S. market. This nightmare scenario is a particularly dramatic example of the kind of temporary shock that can affect a company’s fortunes overnight. More often, shocks take the form of sudden changes in demand, regulation, taxation, personnel, and cost structure. Such jolts also wreak havoc with a firm’s bottom line –– and they lurk around every bend.

 For the first time, new research from the Stanford Graduate School of Business shows that the presence of temporary shocks significantly affects firms’ financial decisions –– and why. The study concludes that the likelihood of such shocks contributes in previously unexplored ways to CFOs’ conservative approach to debt financing, and rightly so. In fact, the investigators suggest that managers should put more focus into risk management.

 ”Firms worry about financial flexibility and earnings volatility more than anything else,” says Ilya Strebulaev, associate professor of finance and Spence Faculty Scholar, a coauthor of the study. “They also use external debt financing conservatively. The average leverage of U.S. public firms is just 25%, with almost a quarter of firms having no debt financing.”

 The problem is that most financial “frictions” –– bankruptcy and liquidation costs, for example –– seem too small to explain such conservative behavior and firms’ worry over financial flexibility and earnings volatility. Past research had not been able to illuminate the issue.

 Using a mathematical model, Strebulaev and Alexander Gorbenko (PhD ’10), who has just assumed a position as assistant professor of finance at London Business School, propose a new explanation for firms’ financial decisions. They argue that it is the worrisome expectation of temporary shocks to their income and free cash flows that govern managers’ conservative behavior.

 Temporary shocks matter because, as the authors show in their model, their impact is “asymmetric.” That means that a shock that is positive –– an unexpected increase in demand, for example –– has far less impact on moving a firm’s financial situation to the good than a negative shock of the same magnitude has to the bad. “If the negative shock is large enough, it can completely jeopardize future profits, leading to bankruptcy or a renegotiated credit line with the bank that is prohibitively costly,” says Strebulaev.

 Prior research missed the mark because it focused on “permanent” shocks –– theoretical long-term events such as a permanent increase in taxes. “Permanent shocks are much easier to study, but most of the shocks in reality are of a temporary nature,” says Strebulaev.

 The authors show that even the presence of shocks lasting less than half a year can explain why managers worry about financial flexibility and pursue conservative financial policies. Theirs is, thus, the first paper to explain why cash-flow volatility is important to financial decision making. “In order to differentiate between permanent and temporary shocks, you need to introduce volatility of short-term income into the equation,” says Strebulaev.

 The research affirms that managers in industries that expect such shocks –– and that means most industries –– indeed should use external debt financing more conservatively. It also suggests that risk management is much more important to corporate financial policies than previously thought. “In many firms, risk management has not yet received enough focus,” says Strebulaev. “Hopefully this paper will help corporate financial management understand the nature of future shocks, try to quantify them, and think about how to hedge against them.”

 –– Marguerite Rigoglioso

Share, Email or Print:
  • Print
  • del.icio.us
  • Facebook
  • Google Bookmarks
  • email
  • LinkedIn
  • MySpace
  • Twitter
  • Yahoo! Bookmarks

Also on Stanford Knowledgebase:

  1. Bankruptcy Laws Drive Corporate Default Rates
  2. Stanford Economist Predicts Large, Short-run Recession”
  3. QOTD: A Conservative Argument for Amtrak

Comments are closed.