Why Do Managers Avoid EPS Dilution?

Date Added: Oct 2009
Format: PDF

Survey and empirical evidence reveals that managers prefer to avoid earnings dilution, though financial theory suggests that it is irrelevant in firm valuation. The paper explores contracting and behavioral explanations for this apparent paradox. Using a large sample of debt/equity issuers, evidence is reported that managers only avoid earnings dilution when their bonus compensation explicitly depends upon Earnings Per Share (EPS) performance; it's further found that this effect is increasing in the magnitude of EPS-contingent bonus compensation. The results are robust to controlling for endogeneity in compensation contract design, behavioral explanations including clientele and investor sentiment theories, and corporate governance policies. The findings provide new evidence on the implications of the contracting role of accounting in firm decision-making.