Managerial ability, purchase obligations and the cost of equity capital

2017-02-24T00:55:25Z (GMT) by Naidu, Dharmendra
The extant literature on operations and supply chain management suggest that recent developments in business environments where firms face extensive competition both locally and globally have given rise to supply chain uncertainties from both upstream and downstream firms. Such competition has led strategic managers to be more concerned about future business operations and production especially due to scarcity of resources. In response to these challenges, a priority for most strategic managers is to secure required levels of production inputs at optimal prices so that their firms face minimal supply chain disruptions by entering into legally binding contractual obligations with suppliers to ensure smooth future production operations. Such contractual obligations were promoted by the Securities and Exchange Commission (SEC) in 2003, when it required non-small business issuers and non-smaller reporting entities in the United States to disclose purchase obligations within a contractual obligations table in the Management Discussion and Analysis (MD&A) section of 10-K filings. Despite such importance and regulatory requirement, there has been a paucity of research on business issues relating to purchase obligations. The purpose of this thesis is to investigate how managerial ability is associated with a firm’s commitment to purchase obligations, and how investors perceive such commitments as implied by the firm’s cost of equity. In order to secure required production inputs, managers need to forecast future product demands. Prior operations management studies suggest that such demand forecasting is complex and forecasts from quantitative models are often not sufficient to accurately predict product demands. A number of studies highlight the importance of managerial expert judgements to complement the quantitative models for better predicting future product demands. Recent studies argue that more able managers can better predict product demands. Hence, it is conceivable that managerial ability is associated with a firm’s commitment to purchase obligations. However, deducing from the investment efficiency studies, a firm’s commitment to purchase obligations can involve forecast errors, which could be either due to honest failure to reliably predict demands or intentional over- or under-commitments due to opportunistic purposes. Based on recent managerial ability studies, more able managers are unlikely to fail to reliability predict product demands given their expert knowledge about the firm and industry trends and ability to synthesize information into forward looking information. On the contrary, a strand of managerial ability studies suggest that more able managers have a “dark side” because they have private information and can create information asymmetry between themselves and other stakeholders, allowing them to better conceal their opportunism. More able managers are likely to engage in opportunistic purchase obligation decisions to build empires and gain from higher compensation, such as equity incentives. On one hand, based on the strand of managerial ability studies which suggest that more able managers are efficient decision makers, it is plausible that managerial ability is associated with required levels of purchase obligations necessary for increased future productions. On the other hand, managerial ability is also likely to be associated with unexpected purchase obligations consistent to the theory of “dark side” of managerial ability. Therefore, in this thesis, I disaggregate total purchase obligations into expected purchase obligations predicted based on a firm’s underlying fundamental growth factors and unexpected purchase obligations to further investigate whether managerial ability is associated with expected purchase obligations, and/or whether managerial ability is associated with unexpected purchase obligations. The initial results show that managerial ability is positively associated with purchase obligations. Upon disaggregating purchase obligations into expected and unexpected purchase obligations, the results further show that managerial ability is positively associated with expected purchase obligations. This result supports the view that more able managers commit to high levels of purchase obligations to hedge against future price increase and inventory shortages. Next, consistent with the opportunistic perspective, the results provide evidence that managerial ability is positively associated with unexpected purchase obligations. These results are robust to the use of propensity score matching analyses and change specifications. A number of additional analyses examine conditions where more able managers are more or less likely to commit to unexpected purchase obligations. The additional analyses show that the positive association between managerial ability and unexpected purchase obligations is more profound for firms providing high equity incentive and it is less profound for firms with high managerial ownership. Given that unexpected purchase obligation is a concern if it is due to opportunism, further analyses examine and provide evidence that unexpected purchase obligations are detrimental to shareholders’ wealth by showing that it is negatively associated with inventory efficiency and future firm performance. Collectively, these results provide evidence that more able managers not only commit to purchase obligations to hedge against price and inventory risks but also to build empires or to enjoy a quiet life, and gain from equity incentives. Since unexpected purchase obligations are detrimental to shareholders wealth irrespective of whether it arises due to forecast errors or managerial opportunism, this thesis further investigates how investors perceive such firm commitments, and whether the investors’ perception is less pronounced for firms with better quality financial reports. Specifically, this thesis next investigates the association between unexpected purchase obligations and the implied cost of equity capital. The results show that unexpected purchase obligations are positively associated with the implied cost of equity capital because it increases the firm’s idiosyncratic risk and analysts’ cash flow dispersion. The results also show that the positive association between unexpected purchase obligations and the implied cost of equity capital is less pronounced for firms with better quality financial reports. Additional analyses show that the association between unexpected purchase obligation and the implied cost of equity capital emanates from over-commitment to purchase obligations and more from long than short horizon unexpected purchase obligations. Moreover, the results provide evidence that unexpected purchase obligations are positively associated with the firm’s realized returns, interest rate and credit ratings. Further results from a propensity score matched sample analysis, change specification and lead-lag regressions imply that the main findings are robust to accounting for endogeneity. Based on the findings that unexpected purchase obligations increase in managerial ability and that it is associated with lower future firm performance and higher cost of financing, the results from this thesis have implications for regulators and standard setters in addition to the contribution they make to the extant literature. Since investors perceive that purchase obligations increase a firm’s business risks, regulators should consider requiring additional disclosures relating to purchase obligations. Similar to the disclosure requirements of major customers, regulators can potentially require disclosure of the names of major suppliers and the amount of purchase obligations from each major supplier. Such disclosures would enable investors to better assess the risks associated with purchase obligations.