Beating earnings benchmarks and the cost of debt
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Prior research documents that firms tend to beat three earnings benchmarks: zero earnings, last year’s earnings, and analyst’s forecasted earnings, and that there are both equity market and compensation-related benefits associated with beating these benchmarks. This study investigates whether and under what conditions the bond market rewards firms for beating these three earnings benchmarks. I use two proxies for a firm’s cost of debt: credit ratings and initial bond yield spread. Results suggest that firms beating earnings benchmarks have better one-year ahead credit ratings and a smaller initial bond yield spread. Additional analyses indicate that (i) the benefits of beating earnings benchmarks are much more pronounced for firms with high default risk (i.e., firms for which earnings are more informative about bondholders’ future payoffs) and (ii) beating the zero earnings benchmark (i.e., the “profit” benchmark) provides the biggest reward in terms of a lower cost of debt. In sum, results suggest that bond investors, similar to equity investors, reward firms for beating earnings benchmarks, but the relative importance of specific benchmarks differs across the equity and bond markets.
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