Firms with CEOs who are financial experts hold less cash and more debt and engage in more share repurchases than other firms. They are less likely to use one company-wide discount rate than a project-specific one. Such CEOs are able to raise external funds even when credit conditions are tight, and they tend to be hired by more mature firms.
The authors study CEOs with a career background in finance. They show that CEOs’ previous financial expertise is correlated with firms’ financial policies; such firms’ cash holdings, capital structures, and share repurchase policies are different from those of firms with nonfinancial CEOs. The authors also investigate the capital budgeting policies and firm financial policies of financial expert CEOs. The financial expert CEOs’ choice of nonfinancial policies, including research and development (R&D), innovation, advertising, and labor costs, is also examined.
How Is This Research Useful to Practitioners?
The authors’ results support the financial skills–based view (i.e., firms with financial expert CEOs are more likely to adopt optimal financial policies). Financial expert CEOs make their firms different from firms with nonfinancial CEOs, and their financial expertise matters.
Regression results indicate that firms with financial expert CEOs hold about 12% less in cash and that their average leverage ratios are 6% higher than the mean. Moreover, these firms are 7% more likely to repurchase shares. The authors also find evidence that the financial expert CEOs are able to issue debt when the default spread is high, perhaps through their ability to better communicate with the markets by reducing information asymmetries. Thus, the smaller cash holdings and higher debt can be explained by their better access to external capital market financing.
The authors note that financial expert CEOs are more aware of finance theory and are more financially sophisticated. For instance, despite textbook capital budgeting, finance theory suggests that firms should value any project using a discount rate determined by the risk characteristics of the project; some firms with multiple divisions may simply discount all the projects with their overall weighted average cost of capital (WACC), regardless of the risk of the projects. Firms committing such a “WACC fallacy” overinvest in high-risk projects. The authors’ results suggest that the WACC fallacy is mainly driven by nonfinancial expert CEOs.
The following findings are also useful to investment practitioners. First, financial expert CEOs are better at communicating firm prospects to other entities in financial markets, as reflected by the lower dispersion in analysts’ forecasts for their firms. Second, financial expert CEOs are more likely to replace the chief financial officer (CFO) because they have a tendency to be more involved in financial policy decisions. The authors argue that financial expert CEOs may be better at identifying weak CFOs and replacing them with more talented ones, although they cannot find any quality difference between the CFOs employed by financial and nonfinancial expert CEOs. Third, financial expert CEOs are more likely to be matched with mature and large firms. Finally, financial expert CEOs spend less on R&D but are more efficient in innovation development; they are less efficient at driving marketing spending into sales.
How Did the Authors Conduct This Research?
The results reveal that financial expert CEOs are less likely to fall into the WACC fallacy, which implies that these firms are less likely to incorrectly accept negative net present value projects. Therefore, the firms that employ the financial expert CEOs probably have higher values. Of course, this conjecture must be investigated rigorously.