Review of Accounting Studies

, Volume 19, Issue 2, pp 877–912 | Cite as

Why do managers avoid EPS dilution? Evidence from debt–equity choice

  • Rong Huang
  • Carol A. Marquardt
  • Bo Zhang


Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt–equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making.


Earnings per share (EPS) Dilution Executive compensation Debt–equity financing Agency conflicts 

JEL Classification

M41 G32 



We wish to thank Patricia Dechow (editor) and two anonymous referees for their comments and suggestions. We also thank Yoel Beniluz, Phil Berger, Mary Ellen Carter, John Core, Merle Ederhof, Aloke Ghosh, Armen Hovakimian, Amy Hutton, David Reppenhagen, Doug Skinner, Abbie Smith, Dan Thornton, Jenny Tucker, Christine Wiedman, Peter Wilson, and participants at the Boston College, Lehigh University, HKUST, SUNY-Buffalo, UT-Dallas, Queens University, and University of Florida accounting workshops, the 2008 AAA Annual Meeting, the 20th Annual FEA Conference, and the 2010 AAA FARS Mid-Year Meeting for their input. We also thank John Graham, Jeffrey Wurgler, and Brian Bushee for providing data.


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Copyright information

© Springer Science+Business Media New York 2013

Authors and Affiliations

  1. 1.Stan Ross Department of Accountancy, Zicklin School of Business, Baruch CollegeCity University of New YorkNew YorkUSA
  2. 2.School of BusinessRenmin University of ChinaHaidian District, BeijingPeople’s Republic of China

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