Managers’ Investment Decisions: Incentives and Economic Consequences Arising from Leases
Round 1
Reviewer 1 Report
First of all, I would like to commend the authors for tackling this innovative topic in a systematic fashion. The logic is rigorous and convincing, the design and method are appropriate and sound, and the paper is also well-written.
Below are a few minor comments for the authors’ reference.
First, while an explicit question re what incentives managers face that might give rise to inefficient investments in leases is asked, the answer to the question is better to be explicitly given as well, especially in the Abstract.
Second, the last three sentences of the first paragraph in the Conclusion section seems to be a repeat of the paragraph in the Intro section.
Third, papers published in JRFM need to be cited to show relevance to the journal and its readers.
Fourth, more recent papers (if any) need to be cited as only three paper published after 2015 were cited.
Good luck to the authors!
Author Response
Reviewer Response Memo
Journal of Risk and Financial Management
Resubmission: “Managers’ Investment Decisions: Incentives and Economic Consequences Arising from Leases”
[Manuscript #1158156]
March 29, 2021
Reviewer 1:
Thank you so much for your positive and constructive review of our manuscript. We have inserted descriptions of our responses to your comments below (inset with ***).
Comments and Suggestions for Authors
First of all, I would like to commend the authors for tackling this innovative topic in a systematic fashion. The logic is rigorous and convincing, the design and method are appropriate and sound, and the paper is also well-written.
Below are a few minor comments for the authors’ reference.
First, while an explicit question re what incentives managers face that might give rise to inefficient investments in leases is asked, the answer to the question is better to be explicitly given as well, especially in the Abstract.
*** Thank you. We have revised the abstract to include a more explicit statement about what our results imply about the consequences of managers’ incentives to make larger-than-expected investments in leased assets.
Second, the last three sentences of the first paragraph in the Conclusion section seems to be a repeat of the paragraph in the Intro section.
*** Thank you, and our apologies. We did not wish to be redundant. We have removed those three sentences in the conclusion. We think those high-level questions, which are (hopefully) clear in the introduction and throughout the paper, do not need repeating in the conclusion. The questions are implied and answered in our discussions of our findings and contributions in the concluding section.
Third, papers published in JRFM need to be cited to show relevance to the journal and its readers.
*** Agreed. We have added one footnote (note 7) and citation referencing a recent article by Elberry and Hussainey (2021), which is very relevant to our study. Unfortunately, our search for additional articles to reference was not very fruitful. A search for keywords of JRFM articles from 1996 to 2021 yielded only 17 articles with the keywords “corporate governance”; only 5 articles with “investment efficiency”; and zero articles with “leases”. This was surprising, given the breadth of topics covered by the JRFM. We are open to adding more references if you have specific articles to suggest that are appropriate for us to cite within our manuscript.
Fourth, more recent papers (if any) need to be cited as only three papers published after 2015 were cited.
*** Yes, we realize that the articles we reference in our manuscript tend to be older, but we have tried to be very careful in citing prior studies that are on point for our study. The article mentioned in the response above, by Elberry and Hussainey (2021), is a small step toward making our references timelier. We conducted another literature search using Google Scholar, but it did not turn up any more recent work that we have not cited already. We are open to adding more references, particularly more timely references, if you have specific articles in mind that are appropriate cites within our manuscript.
Good luck to the authors!
Author Response File: 
Author Response.docx
Reviewer 2 Report
Comments for authors
JRFM 1158156
Managers’ Investment Decisions: Incentives and Economic Consequences Arising from Leases
General comments:
This paper investigates the efficiency of lease financing and its implications. Leases can be inefficient and can be more costly than traditional capital financing, yet even inefficient leases seem to signal to shareholders information on the positive development of the company, thus rising the future expectations of investing public. In line with the agency theory, the managers tend to build a greater empire in expectation to reach superior sales and consequently to gain better rewards. The research concept is well presented.
- Introduction
The introduction provides a background of the problem and motivation of the paper. It highlights the problem and suggests a way of further exploration. The provided introduction shows the intention of the authors well. The suggested structure is about to enrich the current literature stream on the efficiency of leases.
- Related literature and predictions
The part of prior literature explains several streams discussed in the literature. Firstly, the authors analyse literature on Sales, Agency problems and compensation. Sales are the most important factor influencing the CEOs salary.
Secondly, the authors deal with Constraints on over-investment – Free Cash Flows and Financial Reporting Quality. Here the authors summarise that managers tend to overinvest even when further investing in assets is not efficient.
The third part of the literature review concentrates on the economic consequences of leases as a form of leverage.
The last part deals with predictions – stating that “Over-investments in leases lead to higher sales growth and greater CEO compensation but lower earnings growth and stock returns”.
This is also the major thesis of this paper. Literature is well structured and offers avenues to developing ideas around the efficiency of leasing and potential economic effects of over-investment.
Based on literature the authors “…predict that unexpected investments in leases trigger higher future sales growth but lower future earnings growth and lower stock returns. We also predict that higher future sales growth arising from unexpected investments in leases will be associated with higher pay for the managers, despite lower future earnings and returns.” Page [14]
- Research Design and Sample
Authors measure the investments in leases. The sample was selected from the intersection of Compustat and CRSP from 2000 to 2016.
Data are sourced from four dominant industries - Services, Retail, Durable Manufacturers, and Transportation industries.
The regression model is specified together with an expectation regarding the CAPEX financing and lease financing and their links to operating cash flows.
- Empirical Tests and Results
The authors want to extend the literature in all four areas identified in the previous literature. The paper is well designed the empirical part is performed carefully. Results confirm the tested hypotheses.
I find that the most interesting part is the issue on the agency problem and its rationale which is contributing to the theory. The authors also document that higher expectations of investors triggered by investments lead to higher rewards of managers.
Relation to free cash flows and overinvestment or under-investment is also elaborated.
- Conclusion
This study examines the incentives that lead managers to exercise inefficient investments in leases. It also examines the consequences of such decisions. The investigation is well performed, and the findings are relevant and interesting.
The authors confirm that in less efficient leases sales are growing but the earnings are not rising proportionately.
Recommendation of reviewers:
The paper is well written and it extends the knowledge on using leases as an alternative to CAPEX financing on the US market. The effect of inefficient investment in eases is documented. Please, consider extending the analysis to other markets outside the U.S., however, we are aware that the data may be the major limitation of such analysis. I think that the paper needs shortening, but apart from the minor issues discussed in this review, the study is interesting and deals with a relevant problem. In general, the paper is well written, and only minor proofreading is recommended.
Author Response
Reviewer Response Memo
Journal of Risk and Financial Management
Resubmission: “Managers’ Investment Decisions: Incentives and Economic Consequences Arising from Leases”
[Manuscript #1158156]
March 29, 2021
Reviewer 2:
Thank you so much for your positive and constructive review of our manuscript. We have inserted descriptions of our responses to your comments below (inset with ***).
General comments:
This paper investigates the efficiency of lease financing and its implications. Leases can be inefficient and can be more costly than traditional capital financing, yet even inefficient leases seem to signal to shareholders information on the positive development of the company, thus rising the future expectations of investing public. In line with the agency theory, the managers tend to build a greater empire in expectation to reach superior sales and consequently to gain better rewards. The research concept is well presented.
- Introduction
The introduction provides a background of the problem and motivation of the paper. It highlights the problem and suggests a way of further exploration. The provided introduction shows the intention of the authors well. The suggested structure is about to enrich the current literature stream on the efficiency of leases.
*** Thank you. We hope the introduction provides a clear and thorough expectation of the question, methods, results and contribution of our study.
- Related literature and predictions
The part of prior literature explains several streams discussed in the literature. Firstly, the authors analyse literature on Sales, Agency problems and compensation. Sales are the most important factor influencing the CEOs salary.
Secondly, the authors deal with Constraints on over-investment – Free Cash Flows and Financial Reporting Quality. Here the authors summarise that managers tend to overinvest even when further investing in assets is not efficient.
The third part of the literature review concentrates on the economic consequences of leases as a form of leverage.
The last part deals with predictions – stating that “Over-investments in leases lead to higher sales growth and greater CEO compensation but lower earnings growth and stock returns”.
This is also the major thesis of this paper. Literature is well structured and offers avenues to developing ideas around the efficiency of leasing and potential economic effects of over-investment.
Based on literature the authors “…predict that unexpected investments in leases trigger higher future sales growth but lower future earnings growth and lower stock returns. We also predict that higher future sales growth arising from unexpected investments in leases will be associated with higher pay for the managers, despite lower future earnings and returns.” Page [14]
*** Thank you. Yes, our paper is complex because it touches on so many different areas of prior literature. We have tried to create a literature review and predictions section that covers all of the bases and clearly motivates our research questions, without being too lengthy.
- Research Design and Sample
Authors measure the investments in leases. The sample was selected from the intersection of Compustat and CRSP from 2000 to 2016.
Data are sourced from four dominant industries - Services, Retail, Durable Manufacturers, and Transportation industries.
The regression model is specified together with an expectation regarding the CAPEX financing and lease financing and their links to operating cash flows.
*** Thank you. To clarify a bit, our sample draws firm/year observations from all firms with available data during our sample period, not just from four industries. But it is correct to observe that, as Table 1 Panel B shows, those four industries end up with the largest numbers of observations in our sample. This is not too surprising, given the extent to which those industries are known to rely on leased assets (services: service locations and offices; retail: store locations and warehouses; durable manufacturers: plant and equipment and vehicles: transportation: planes, trucks, ships, rail cars, and containers).
- Empirical Tests and Results
The authors want to extend the literature in all four areas identified in the previous literature. The paper is well designed the empirical part is performed carefully. Results confirm the tested hypotheses.
I find that the most interesting part is the issue on the agency problem and its rationale which is contributing to the theory. The authors also document that higher expectations of investors triggered by investments lead to higher rewards of managers.
Relation to free cash flows and overinvestment or under-investment is also elaborated.
*** Thank you. We have tried to design our empirical tests to provide evidence on many dimensions of investments in leases: managers’ incentives that can lead to investments in leases, the free cash flow constraints on those investments, the sales and earnings growth consequences, stock market consequences, and finally, the consequences for managers’ compensation.
- Conclusion
This study examines the incentives that lead managers to exercise inefficient investments in leases. It also examines the consequences of such decisions. The investigation is well performed, and the findings are relevant and interesting.
The authors confirm that in less efficient leases sales are growing but the earnings are not rising proportionately.
*** Thank you.
Recommendation of reviewers:
The paper is well written and it extends the knowledge on using leases as an alternative to CAPEX financing on the US market. The effect of inefficient investment in eases is documented. Please, consider extending the analysis to other markets outside the U.S., however, we are aware that the data may be the major limitation of such analysis. I think that the paper needs shortening, but apart from the minor issues discussed in this review, the study is interesting and deals with a relevant problem. In general, the paper is well written, and only minor proofreading is recommended.
*** Thank you. To clarify a bit, we do not limit our study to U.S. firms. We draw our sample from all firms in the intersection of CRSP and Compustat, which includes non-U.S. firms that are SEC registrants. We acknowledge that the selection procedure and data requirements will result in our sample being predominantly but not exclusively based on U.S. companies. We are not aware of any major differences in managers’ incentives (or cash flow constraints) to invest in leased assets, or accounting for operating leases, or other factors that would cause our results to be unique to U.S. firms only and not generalize more broadly. We are open to re-evaluate the generalization of our findings if you have specific concerns about how or why our findings will not hold for firms outside the U.S. and can suggest available data sources. [However, if a re-evaluation is necessary, it will lengthen an already lengthy paper.]
Author Response File: Author Response.docx
