Fariz Huseynov

Government as the Firm’s Third Financial Stakeholder: Impact on Capital Investment Decisions, Capital Structure, Discount Rates, and Valuation

We extend Myers’ (1974) adjusted present value method and modify Modigliani and Millers (1958, 1963) capital structure propositions by adding government as the firms’ third major financial stakeholder. Government is a major stakeholder because it collects income taxes, is instrumental in establishing the business environment, and provides business infrastructure to corporations. We assume that governments stake is an implicit form of capital and, consequently, any return or benefit derived by the firm from this implicit capital will affect firm value. As a result, tax structure significantly impacts relative stakeholder values, capital investment decisions, and capital formation. Only in the special case when the firm receives explicit benefits and when the return on governments implicit capital is equal to the firms cost of equity capital will corporate taxes not impact firm value and capital investment decisions. Although tax irrelevance and the conservation of value principle may hold true within a domestic economy with a homogenous tax structure, our three-stakeholder model demonstrates that corporate income taxes become relevant for investment decisions in a globally competitive economy with heterogeneous tax structures. Thus, our model addresses the apparent inconsistencies between existing theory, which characterizes corporate taxes as nondistortionary, and empirical findings, which demonstrate that taxes reduce investments, growth, and valuation ratios.

Government as the Firm's Third Financial Stakeholder: Impact on Capital Structure Discount Rates and Valuation

We extend Myers’ Adjusted Present Value method (Myers, 1974) and modify Modigliani and Miller’s capital structure propositions (MM 1958, 1963) by adding government as the third major financial stakeholder. Stockholders, bondholders and government (federal and state) each possess a stake in the firm because of the potential to receive future cash flows. Given MM however, have major effects on relative stakeholder values and appropriate discount rates. Considering the three stakeholder model helps clarify the controversy over appropriate discount rates for each stakeholder’s cash flows, the social discount rate and tax structure. We further extend our models in an intertemporal framework that allows for reinvestment of earnings and firm growth. This extension provides clarification and has significant implications regarding firm valuation, capital investment and capital structure policy. We demonstrate that the corporate tax burden ultimately falls on shareowners and government is the beneficiary, whether the tax incidence is at corporate or individual level. However, corporate taxes may significantly impact domestic corporations’ abilities to compete in a global economy. In an intertemporal framework, shifting the tax burden from corporations to individuals and lowering the overall tax rates may increase government’s tax revenues through corporate growth despite a reduced proportional stake in firms.

Real Exchange Rate Misalignment in Azerbaijan

By using quarterly data from 2001-2007 and applying various approaches, we estimate real equilibrium exchange rate misalignment for Azerbaijani Manat (AZN) and find that AZN is slightly overvalued. Purchasing power parity approach does not explain the equilibrium exchange rate. However using behavioral and permanent equilibrium exchange rate approaches, we find that the relative productivity, terms of trade, trade openness, net foreign assets, government expenditures and oil prices are the main determinants of misalignment.

Can Paying Taxes Substitute for Corporate Social Responsibility? Evidence from Socially Responsible Investment Funds

We examine whether corporate tax avoidance impacts the investment decisions of socially responsible investment (SRI) funds. After controlling for corporate social responsibility (CSR) constructs, we find that investment by SRI funds is negatively associated with corporate tax avoidance. Further analysis indicates that greater tax avoidance leads to less SRI fund investment particularly in firms with CSR concerns, greater managerial entrenchment, and greater earnings management. Our results suggest that socially responsible investors consider corporate tax avoidance an important aspect of CSR. The results are consistent with recent findings in the literature that corporate tax avoidance is a part of corporate culture, and that corporate insiders view tax avoidance and CSR as substitutes. When corporate culture is likely to promote less responsible activities and greater agency issues in the firm, corporate tax avoidance deters investment by socially responsible investors. However, tax avoidance does not deter investment by social responsible investors in firms with a strong CSR reputation.We examine whether corporate tax avoidance impacts the investment decisions of socially responsible investment (SRI) mutual funds. After controlling for corporate social responsibility (CSR) constructs, we find that investment by SRI funds is positively associated with paying corporate taxes. Whereas corporate tax avoidance does not affect SRI fund investment in firms with a strong CSR reputation, greater tax avoidance leads to significantly less SRI fund investment in firms as their CSR reputation weakens. These results hold after accounting for selection bias, controlling for earnings management and managerial entrenchment, and performing several robustness checks. Our findings suggest that socially responsible investors consider corporate tax avoidance an important aspect of CSR and they are consistent with recent findings in the literature that corporate insiders view paying taxes and CSR as substitutes.

Do Mutual Funds Consider Tax Avoiding Firms Too Risky

We document evidence that mutual funds, on average, are averse to investing in tax-avoiding firms, which seems anomalous given mutual fund managers’ incentive structure. Our results remain unchanged when we address endogeneity concerns using several methods, including identification through instrumental variables, difference-in-differences, and matching methodologies, and after running a litany of robustness checks. We also find that poor-performing mutual funds reduce their ownership in tax-avoiding firms, a result inconsistent with both fund managers’ incentive and diversification motives. Furthermore, mutual funds’ aversion to tax-avoiding firms persists regardless of the mutual funds’ investment horizons.

EARNINGS MANAGEMENT AND SHORT SELLING AROUND EARNINGS ANNOUNCEMENTS

In this paper, we examine the impact of earnings management on the behavior of short sellers around the time of earnings announcements. Our major finding is that activity-based earnings management (real earnings management) is a type of accounting information short sellers exploit. In addition, we find that the interaction between real earnings management and information asymmetry in the market also contributes to the decision process of short sellers. Short sellers target firms with high levels of real earnings management, particularly when information asymmetry concerning the firm is most severe. We also find weak evidence that short sellers trading on announcement day have some information advantage that most likely stems from processing public information rather than accessing private information. Our findings have implications to the capital market participants. If short sellers take a long position in low earnings management firms and a short position in high earnings management firms, they may earn positive abnormal returns.