Agency Costs and Equity Mispricing

AuthorJung Chul Park,Christos Pantzalis
Date01 February 2014
DOIhttp://doi.org/10.1111/ajfs.12041
Published date01 February 2014
Agency Costs and Equity Mispricing*
Christos Pantzalis
Department of Finance, College of Business, University of South Florida
Jung Chul Park**
Department of Finance, Harbert College of Business, Auburn University,
Received 30 September 2013; Accepted 19 December 2013
Abstract
We investigate a link between agency costs and equity mispricing. We employ comprehensive,
multi-dimensional measures of agency costs and mispricing, and find that mispricing is sig-
nificantly and positively related to agency costs. We also explore the effect of equity-based
compensation on the impact of agency costs on mispricing. Our investigation extends previ-
ous studies that do not separately account for the options and restricted stock grants compo-
nents of equity-based compensation. We show that stock options, originally intended to
resolve conflicts of interest, exaggerate the problem and this phenomenon is pronounced
especially when firms are overvalued. Overall, our results imply that compensation packages
that are not structured optimally could lead to greater mispricing.
Keywords Agency costs; Equity-based compensation; Equity mispricing
JEL Classification: G12,G14,G34,M12
1. Introduction
Both theory and empirical evidence support the notion that equity mispricing has
an impact on managers’ investment and financing decisions. For instance, misv alua-
tion can drive firms’ takeover behavior (Shleifer and Vishny, 2003; Rhodes-Kropf
and Viswanathan, 2004; Rhodes-Kropf et al., 2005; Dong et al., 2006). The levels of
firms’ investment are affected by inefficient market valuations (Baker et al., 2003;
Polk and Sapienza, 2009). Furthermore, firms may try to time equity issues to take
*We are especially grateful to the editors (Hee-Joon Ahn, Kee H. Chung, and Bong-Soo Lee),
J. Barry Lin, James L. Park, J. Qi, and Ninon Sutton for their many insightful and construc-
tive suggestions. We appreciate helpful comments from participants in seminars at the
University of South Florida, the 2013 Annual Conference on Asia-Pacific Financial Markets,
the 2008 Eastern Finance Association Annual Meeting, and the 2007 Financial Management
Association Annual Meeting.
**Corresponding author: Jung Chul Park, Department of Finance, Harbert College of Busi-
ness, Auburn University, Auburn, AL 36849, USA. Tel: +1-334-844-3003, Fax: +1-334-844-
4960, email: jzp0023@auburn.edu.
Asia-Pacific Journal of Financial Studies (2014) 43, 89–123 doi:10.1111/ajfs.12041
©2014 Korean Securities Association 89
advantage of misvaluation (Ritter, 1991; Loughran and Ritter, 1995; Rajan and
Servaes, 1997; Baker and Wurgler, 2002).
A stream of research establishes two different views on equity mispricing. These
are related to market imperfections such as information asymmetry, transactions
costs, lack of investor sophistication, or unequal access to prices or information
(e.g. noise trading, see Roll, 1988). In efficient markets with rational asset pricing,
stock mispricing can be either a short-term, temporary phenomenon quickly revers-
ible by arbitrageurs (Friedman, 1953), or rational compensation for systematic risks
that are not accounted for in asset pricing models (see, e.g. Fama and French, 1993,
1996). On the other hand, behavioral finance regards persistent mispricing as the
result of an irrational (behavioral) component to asset prices.
This paper extends the current understanding by providing evidence that equity
mispricing could be the result of conflicts of interest and incentive problems within
the firm, rather than suggesting that equity mispricing is solely determined by the
markets. According to agency theory, agency costs are associated with divergent
objectives between agents (managements) and owners (shareholders). These con-
flicts of interest are caused by the presence of information asymmetry where agents
discriminately have better/more information than owners. If there is no information
asymmetry, conflicts of interest can be solved simply by fully informed stockhold-
ers. However, even without conflicts of interest, information asymmetry can cause
mispricing. Suppose, for instance, that there are large differences in the quality and
availability of information between managers and outside investors of a particular
firm. Then, one may expect that the firm’s stock is likely to be valued incorre ctly
because ambiguity about future cash flows leads to stock mispricing (Zhang, 2006).
The question that we want to examine is what happens to the size of mispricing,
given the serious information asymmetry, in cases where there is also conflict of
interest between managers and shareholders. While some prior studies have argued
that there is a link between information asymmetry and stock misvaluation (Nanda
and Narayanan, 1999; Healy and Palepu, 2001), there is little direct empirical evi-
dence in the literature of the effect of agency costs on equity mispricing. We
employ several measures of information asymmetry and conflicts of interest to
devise a composite measure of firms’ likelihood to display agency problems, which
we call the agency costs index. We also devise a composite equity mispricing mea-
sure, the mispricing index, that combines four different relative valuation measures
and an abnormal return measure. We test whether the two indices are significantly
related after controlling for other factors that are associated with mispricing.
In our analysis we also examine the role of managerial compensation structures,
in particular equity-based (incentive) compensation, in the relationship between
agency costs and mispricing. Equity-based compensation, in general, is theoretically
known as the most effective tool firms can use to align managerial interests with
those of shareholders but not necessarily as a tool suited to resolving information
asymmetry. However, recent financial scandals (e.g. those associated with Enron or
Worldcom) and academic evidence (see, e.g. Bergstresser and Philippon, 2006) have
C. Pantzalis and J. C. Park
90 ©2014 Korean Securities Association
raised serious questions about the validity of this view. If incentive-laden compensa-
tion packages are not structured optimally, they may fail to resolve or they may
even exacerbate conflicts of interest, thereby causing an even stronger positive effect
of agency problems on equity mispricing. Thus, if our conjecture is correct, the
level of mispricing should be related to components of managerial compensation
packages that are intended to resolve the conflicts of interest. In addition, the two
components of incentive compensation, options grants and restricted stock grants,
have been shown to induce opposite results. While options have been shown to
induce managerial myopia (i.e. shorter-term orientation, see Watts and Zimmer-
man, 1986; Aboody and Kasznik, 2000; Sanders, 2001; Gao and Shrieves, 2002;
Bergstresser and Philippon, 2006), restricted stock grants have been shown to
induce managers to become less myopic (i.e. longer-term orientated, see Narayanan ,
1996; Bryan et al., 2000). Therefore, based on the conflicting theoretical and empiri-
cal evidence, the role of equity-based compensation on the relationship between
agency costs and mispricing remains an empirical question. Our study sheds light
on this important issue by examining both major equity-based compensation com-
ponents, that is, stock options and restricted stock grants, and testing whether and
how they enhance the relationship between agency conflicts and mispricing.
Our results show a significant positive relation between agency problems and
equity mispricing. Furthermore, using chief executive officer (CEO) incentive com-
pensation data, we find evidence consistent with the notion that conflicts of interest
are significantly exacerbated in certain cases, leading to greater mispricing. When
we interact agency costs proxies with variables that capture managerial equity-based
compensation components intended to resolve the conflicts of interest between
CEO and owners, our models explain an additional significant proportion of mis-
pricing. Our findings obtained from several univariate and regression tests support
the notion that the positive relation of agency costs with mispricing is, to some
extent, driven by myopia-inducing stock options’ awards to the CEO. This evidence
may indicate that stock option grants increase the value of overvalued firm s, but
decrease the value of undervalued firms. One may argue that shareholders would
not be willing to provide stock options if the latter case were expected. Therefore,
we retest the mispricing models to examine if the effects of information asymmetry
and conflicts of interest on mispricing are different for overvalued and undervalued
firms. When we examine overvalued and undervalued firms separately, we find that
the overall effect of agency costs on mispricing is much stronger for undervalued
firms. The total impact of agency conflicts on poor performing firms’ value is
almost double that of the corresponding impact of agency conflicts on good per-
formers’ value. Furthermore, option awards are solely responsible for the positive
relationship between agency conflicts and overvaluation, while the impact of agency
conflicts on undervaluation is not affected by options grants. This evidence is con-
sistent with Jensen’s (2004) argument that several aspects of managerial behavior
act as potential sources of the agency costs of overvalued equity. It also comple-
ments prior studies that document the opportunistic behavior of executives with
Agency Costs and Equity Mispricing
©2014 Korean Securities Association 91

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