Pension Plan Contributions, Free Cash Flows and Financial Slack

Legend: Bold indicates significant at .01 level of significance

Bold and italic indicates significant at .05 level of significance

Italic indicates significant at .10 level of significance

Notes:

1. GCAPEX_t is capital expenditures in year t divided by the average capital expenditures in years t-3 through t-1.

2. ROA_t is the return on assets in year t, defined as income before extraordinary items during year t, divided by total assets at the end of year t.

3. INDROA_t is industry-adjusted ROA at period t, estimated by ROA_t minus the median ROA_t in the same 4-digit SIC industry.

4. AROA_t is the average of ROA_t over the three-year period t to t+2.

5. AINDROA_t is the average of INDROA_t over the three-year period t to t+2.

6. ANNRET_t is the annual stock return in year t, beginning April 1, year t through March 31, year t+1.

7. CUMRET_t is the cumulative return (ANNRET) during the period April 1, year t, through March 31, year t+2.

8. SIZERET_t is the size-adjusted annual return in year t. It is defined as ANNRET_t minus the equally-weighted average return (ANNRET_t) of all stocks that belong to the same size (market value of equity) decile at the beginning of year t.

9. CUMSIZERET_t is the cumulative SIZERET during the period April 1, year t, through March 31, year t+2.

EXHIBIT 6

Results of tests for Hypothesis 2 and 3 for firms with Market to Book ratio < 1.

Panel A : Results of tests of Hypothesis 2

		ID			II		t-test	Wilcoxon
	N	Mean	Median	N	Mean	Median	Sig.	Sig.
Growth in capital expenditures
GCAPEX	225	1.230	1.060	441	1.120	1.000	0.050	0.092
GCAPEX t+1	210	1.260	1.070	405	1.220	1.100	0.376	0.478
Profitability measures
ROAt+1	217	0.020	0.030	425	-0.050	0.020	0.186	0.004
INDROAt+1	217	-0.020	0.000	425	-0.090	-0.010	0.422	0.103
AROAt+1	217	0.020	0.030	428	-0.070	0.020	0.167	0.012
AINDROAt+1	217	-0.020	0.000	428	-0.100	-0.010	0.190	0.247

Panel B : Results of tests of Hypothesis 3

		ID			II		t-test	Wilcoxon
Return Measures	N	Mean	Median	N	Mean	Median	Sig.	Sig.
ANNRETt+1	142	39.390	22.250	274	27.420	11.500	0.151	0.018
CUMRETt+1	64	92.480	54.800	140	78.570	59.950	0.224	0.304
SIZERETt+1	142	16.330	4.400	274	10.060	-3.100	0.295	0.061
CUMSIZERETt+1	488	2.587	-7.300	949	0.504	-9.800	0.271	0.244

Legend: Bold indicates significant at .01 level of significance

Bold and italic indicates significant at .05 level of significance

Italic indicates significant at .10 level of significance

Notes:

1. 
   GCAPEX_t is capital expenditures in year t divided by the average capital expenditures in years t-3 through t-1.
   
2. 
   ROA_t is the return on assets in year t, defined as income before extraordinary items during year t, divided by total assets at the end of year t.
   
3. 
   INDROA_t is industry-adjusted ROA at period t, estimated by ROA_t minus the median ROA_t in the same 4-digit SIC industry.
   
4. 
   AROA_t is the average of ROA_t over the three-year period t to t+2.
   
5. 
   AINDROA_t is the average of INDROA_t over the three-year period t to t+2.
   
6. 
   ANNRET_t is the annual stock return in year t, beginning April 1, year t through March 31, year t+1.
   
7. 
   CUMRET_t is the cumulative return (ANNRET) during the period April 1, year t, through March 31, year t+2.
   
8. 
   SIZERET_t is the size-adjusted annual return in year t. It is defined as ANNRET_t minus the equally-weighted average return (ANNRET_t) of all stocks that belong to the same size (market value of equity) decile at the beginning of year t.
   
9. 
   CUMSIZERET_t is the cumulative SIZERET during the period April 1, year t, through March 31, year t+2.
   

1 A number of studies have used Jensen’s “free cash flow” hypothesis to examine merger behavior (Lang et al (1991)), levels of R&D expenditures (Szewcyzk et al (1996)) and dividend payout policy (Kallapur (1994)).

2 Alternatively debt may be paid down increasing future debt capacity.

3 Two examples of papers which attempted to distinguish between these theories in the context of merger behavior are Smith and Kim (1994) and McCabe and Yook (1997).

4 Although, Myers and Majluf, themselves, do not list it as one of their alternatives, the use of pension plans to build financial slack has been suggested by Bodie et al (1985 and 1987).

5 See, for example, Mittelstaedt (1989) who showed that by changing interest rate assumptions firms were able to access pension funds.

6 See Thomas (1989).

7 We stress currently, because as of 1998, under the new accounting disclosure requirements mandated by SFAS 132, contribution levels will be a required disclosure,

8 The tax code places an upper limit on the employer contributions that are tax deductible.

9 See Appendix to paper. Data to calculate pension contributions and benefits paid were available on the Compustat Files only since 1991.

10 In some cases, the estimate of pension contribution (and/or benefits paid) is negative, mostly due to acquisitions, divestitures, or termination of certain plans. In such cases, the firm is excluded from analysis.

11 In an earlier version of the paper, we used as one of control variables the change in the discount rate used in the pension assumptions. The results were similar to those presented. As this variable, by definition, results in one year of observations (1991) being lost and whenever the data point (discount rate) is missing, it results in the loss of two years of observations, we do not present results for this variation.

12 We used various other definitions for tax rates, including a dummy variable for NOL, and the tax expense divided by pretax income but the results were qualitatively similar to those presented.

13 As we are only focusing on the relationship between CONTA and PENROA, we only present results for the coefficients (b_2y) on PENROA. The coefficients on the other variables were similar to those reported in Exhibit 3.

14 The measurement error results from items relating to acquisitions, discontinuities and settlements.