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Essays on Prospect Theory and Cost Structures

Liu, Xiaosi
http://rave.ohiolink.edu/etdc/view?acc_num=kent1659625606548568

Abstract Details

2022, PHD, Kent State University, College of Business and Entrepreneurship, Ambassador Crawford / Department of Accounting.
This dissertation consists of two essays on the impact of negative prospects on firm cost structures. It focuses on cost behavior for two reasons. First, cost structures, also known as operating leverage, play an important role in the level and the risk of a firm's profitability, and second, a firm's cost structure is largely determined by its managers' decisions and mirrors a vast range of operating decisions. The prospect theory argues that people may exhibit different behaviors on the same issue depending on whether these people frame the results as gains or losses. Specifically, based on prospect theory, people are risk-averse in the gain frame, preferring a sure gain to a speculative gamble, but are risk-seeking in the loss frame, tending to choose a risky gamble rather than a sure loss. It is important to investigate whether negative prospects can cause firms' risk-taking behavior because such risk-taking behaviors are usually value-destroying and associated with inferior subsequence performance. Given the evidence provided by the prospect theory literature, I conjecture and prove a controversial argument that when firms and their executives face negative prospects, these firms will adopt a rigid cost structure. In this dissertation, I examine two examples of negative prospects. The first essay examines the association between earnings or demand downside risks and firms' cost behavior and argues that firms may adopt rigid cost structures when they face earnings or demand downside risks. Traditional wisdom believes that when firms face high risk, especially high downward risk, they should adopt a flexible cost structure. Konchitchki et al. (2016) estimate a firm's earnings downside risk by comparing the realized earnings with the expected ones. Following their method, this essay develops an estimate for demand downside risk and proves that it is associated with firms' subsequent demand as well as subsequent operating performance. According to the prospect theory, the expected levels usually serve as a strong reference target for people to frame the results. Both earnings downside risk and demand downside risk suggest that firms' performance is below expectations. With such downward risks, managers may negatively frame their situations and seek additional risks to avoid these negative prospects. Their decisions will eventually be reflected in their firms' operating leverage or cost structures. Thus, based on prospect theory, this essay argues and finds that when firms face earnings or demand downside risk, they would adopt rigid cost structures. The second essay examines the associations between executive underwater stock options and their firms' cost behavior and finds that CEOs' underwater stock options are positively associated with their firms' cost rigidness. Equity-based compensation like stock options provides a direct link between executive compensation and shareholder wealth and aligns the interests of a firm's executives with those of its shareholders. When stock options fall underwater, it is usually believed that these stock options' pay-to-performance sensitivities become weaker and lose their incentives. Due to the nature of stock options, their exercise price can be an important reference level for their holders to frame their situations. Based on the prospect theory, executives are likely to frame their underwater stock options as negative prospects and thus will seek risks to avoid the deemed losses. This essay proposes and finds that when executives own underwater stock options, their firms are likely to adopt a rigid cost structure with high fixed costs and low variable costs.
Shunlan Fang (Committee Co-Chair)
Dandan Liu (Committee Member)
Pervaiz Alam (Committee Co-Chair)
195 p.
Accounting
prospect theory, negative prospects, risk-seeking behavior, cost structure, executive compensation, underwater stock options, earnings downside risk, demand downside risk

Recommended Citations

Citations

  • Liu, X. (2022). Essays on Prospect Theory and Cost Structures [Doctoral dissertation, Kent State University]. OhioLINK Electronic Theses and Dissertations Center. http://rave.ohiolink.edu/etdc/view?acc_num=kent1659625606548568

    APA Style (7th edition)

  • Liu, Xiaosi. Essays on Prospect Theory and Cost Structures. 2022. Kent State University, Doctoral dissertation. OhioLINK Electronic Theses and Dissertations Center, http://rave.ohiolink.edu/etdc/view?acc_num=kent1659625606548568.

    MLA Style (8th edition)

  • Liu, Xiaosi. "Essays on Prospect Theory and Cost Structures." Doctoral dissertation, Kent State University, 2022. http://rave.ohiolink.edu/etdc/view?acc_num=kent1659625606548568

    Chicago Manual of Style (17th edition)

kent1659625606548568
245
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This open access ETD is published by Kent State University and OhioLINK.