relevant to the extent that shark repellent-adopting firms can be characterized by
relatively high levels of capital spending and R&D investment.
The potential relevance of dividend policy and capital structure decisions is
suggested by Jensen’s (1986) free cash flow hypothesis, which recognizes high
dividend payout ratios and high debt-to-equity (leverage) ratios as effective
means for controlling the agency costs of free cash flow. If the self-interested
management of shark repellent-adopting firms is typically insulated from market
discipline, a significant amount of slack should be observed in these commonly
employed corporate control mechanisms. Thus, the managerial-entrenchment
hypothesis would predict relatively low dividend payout ratios and low leverage
for shark repellent-adopting firms during the pre- and postadoption periods.
Conversely, if shark repellents are adopted by firms with managers who are
highly motivated to maximize shareholder value, high dividend payout ratios and
high leverage should be typical. It follows that effective constraints on the agency
costs of free cash flow during the pre- and postadoption periods are consistent
with the competing shareholder-interest hypothesis. By considering the link
between shark repellent adoptions, investment policy, dividend policy, and lever-
age during the pre- and postadoption periods, it becomes possible to arrive at
some discriminating evidence concerning the predictive capability of the man-
agement-entrenchment and shareholder-interest hypotheses.
IV. MEASURES OF LONG-TERM PERFORMANCE AND
FINANCIAL POLICIES
The cash flow margin on sales reflects the ability of the firm to generate a profit
contribution on each dollar of sales revenue. Following Healy, Palepu, and
Ruback (1992), the cash flow margin on sales (CFMS
t
) employed in this study is
(9.1)
where CF
t
is cash flow defined as net income plus depreciation.
2
This cash flow-
based measure of profitability is used rather than a more traditional approach in
order to minimize the influences of accrual accounting conventions and firm-by-
firm differences in accounting policy choice decisions. Whereas a high cash flow
margin indicates a commensurately high rate of operating efficiency, a low cash
flow margin on sales can reflect the fact that expenses are out of control. Of
course, the cash flow margin on sales is related to the effectiveness of the firm’s
operating policies and to the vigor of industry competition.
CFMS
CF
SALES
t
t
t
= ,
210 CHAPTER 9 SHARK REPELLENTS AND RESEARCH AND DEVELOPMENT
2
From Compustat, INC_DEP (Compustat item #13) is used for income before depreciation, and
DEPREC (Compustat item #14) is used for depreciation.
MEASURES OF LONG-TERM PERFORMANCE AND FINANCIAL POLICIES 211
The cash flow return on assets demonstrates how effective the firm is in
employing its assets. Not only does the cash flow return on assets indicate
whether or not the firm is able to generate profits on assets already in place, it also
offers a suggestion of the firm’s future growth prospects. Following Healy,
Palepu, and Ruback (1992), the cash flow return on assets (CFMV
t
) is defined as
(9.2)
Again, to minimize measurement problems, market values rather than accounting
book values of assets in place at the end of the prior year are employed.
Total asset turnover reflects the firm’s ability to generate sales relative to the
firm’s asset base. Higher ratios indicate a relatively efficient use of assets when
the total asset turnover (TAT
t
) ratio is defined as
(9.3)
and MV
t1
is market value defined as total liabilities, plus the book value of pre-
ferred, plus the market value of common equity for the year prior to the shark
repellent adoption period. The market value of common equity is calculated as
the common stock price at the beginning of the year times the number of shares
outstanding.
3
Like in Healy, Palepu, and Ruback (1992), the market value of the
firm is used rather than the more traditional book value of assets in the calcula-
tion of the total asset turnover ratio. This approach is designed to minimize the
effects of differences in accounting policy choice decisions among firms.
In addition to these accounting-based measures of firm performance in the
pre- and postadoption periods, it is worth considering performance measures
more directly tied to shareholder returns. A simple market-based performance
measure is the total stock price plus dividend return (TR
t
) defined as
(9.4)
where P
t
is the closing price for year t, P
t1
is the prior-year closing price, and D
t
is the dividend paid in year t. TR
t
is an attractive measure of the total (capital
gains plus dividend) return earned by long-term shareholders.
TR
PP D
P
t
tt t
t
=
−+
1
1
,
TAT
SALES
MV
t
t
t
=
1
,
CFMV
CF
MV
t
t
t
=
1
.
3
From Compustat, LIABTOT (Compustat item #181) is used for total liabilities, and PS_CVAL
(Compustat item #130) is used for the book value of preferred stock. AD_CLOSE (same as closing
price, CLOS_PR, Compustat item #24, after adjusting for stock splits and dividends) is used for the
closing stock price at the end of the year, and ADJ_TRAD (same as common shares traded,
CS_TRADE, Compustat item #28, after adjusting for stock splits an dividends) is used for the number
of shares outstanding.

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