Legal Protection, Equity Dependence and Corporate Investment: Evidence from Around the World

NTU International Conference in Finance (Taipei)

SFM Conference (Kaoshiung)Dec 2006

YUANTO KUSNADI and K.C. JOHN WEI

Department of FinanceSchool of Business and

ManagementHKUST

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Outlines of Presentation

Introduction Summary of Results Related Literature and Main

Hypotheses Data Empirical Results Conclusion

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Introduction Investment equation:

Q-theory: corporate investment is positively associated to stock prices (Tobin’s Q).

Two explanations: Stock prices reflect investment opportunities The equity-financing channel

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Introduction Law and Finance literature: impact of

country-level institutional characteristics (such as legal protection of minority shareholders) on various aspects of financial markets.

Behavioral Finance literature: stock markets may not be efficient Non-fundamental component in stock prices

(mispricing) Equity-financing channel argument

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Introduction Motivation:

Few studies examine if cross-country differences in institutional characteristics could determine

firm-level corporate investment decisions. Very little is known regarding the relationship

between corporate investment and the stock market outside the U.S.

Objectives and Contributions: Examine the role of legal protection and the

equity-financing channel on the sensitivity of corporate investment to stock prices.

No previous study has empirically examined these issues simultaneously.

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Summary of Results Positive relationship between legal protection of

investors and investment-to-price sensitivity. Investment-to-price sensitivity also increases

monotonically with the degree of equity-dependence

Role of the equity-financing channel. The positive association between legal protection

and investment-to-price sensitivity is more pronounced for equity-dependent firms.

Therefore, both legal protection and the equity-financing channel influence managers’ corporate investment decisions with respect to changes in stock prices.

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Related Literatures Corporate investment and stock prices

Focus on the equity-financing channel. Stein (1996); Baker et al. (2003) Empirical evidence is mixed:

Morck et al. (1990) and Blanchard et al. (1993): stock market is a sideshow!

Chirinko and Schaller (2001); Baker et al. (2003); Chen et al. (2005): the stock market matters!

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Related Literatures The role of legal protection:

Rights prescribed by regulations and laws + effectiveness of enforcement.

LLSV (1997, 1998, 2002): effect of legal protection LLSV (2006): effect of securities laws Chen et al. (2005) & Hail and Leuz (2006):

relationship with cost of capital. Wurgler (2000): capital market development

promotes efficient allocation of capital.

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Hypothesis 1 The role of legal protection (cont’d):

Agency problems inefficient corporate investment decisions .

Mitigated by strong legal protection. For those firms in countries with strong legal protection:

stock prices should reflect more innovation in investment opportunities more efficient allocation of capital.

Baker et al. (2003): an increase in the investment-to-price sensitivity greater efficiency in capital allocation.

Hypothesis 1: Firms in countries with strong legal protection have corporate investment that is more sensitive to their stock prices.

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Hypothesis 2 Baker et al. (2003):

Extends the model in Stein (1996) and derive implications on the role of the equity-financing channel on corporate investment.

Effect of stock market irrationality on investment decisions of nonequity-dependent and equity dependent firms.

Hypothesis 2: Equity-dependent firms have corporate investment that is more sensitive to their stock prices than do nonequity-dependent firms.

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Related Literatures Baker et al. (2003) (cont’d):

Agency problems further increases the incentives of managers of nonequity-dependent firms to smooth investments.

Almeida and Wolfenzon (2005): Both investor protection and equity dependence affect the

efficiency of capital allocation As the level of legal protection increases, managers have to

switch to more productive projects. The presence of financial constraints further ensure

managers’ commitment in the termination of average projects.

Hypothesis 3: The effect of legal protection on the sensitivity of corporate investment to stock prices is more pronounced for equity dependent firms than for nonequity-dependent firms.

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Data Legal protection measures:

Anti-directors rights, private and public enforcement (LLSV) Firm-level financial data (Worldscope and

Datastream): Capital expenditures, cash-flow, Tobin’s Q, and variables

required to construct the KZ-Index Exclude financial firms; firms with book equity < US$10

million; firms with missing firm-year observations Use modified KZ-Index as in Baker et al. (2003) as measure of

equity-dependence:

Also use the “adjusted” KZ-Index by resetting the weights of the components of the index for each country.

Unbalanced panel data consisting of 110,082 firm-year observations for 17,009 firms in 43 countries, from 1985-2004

ititititit LEVCASHDIVCFKZ 139.3315.1368.39002.1

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Table 2 – Univariate Analysis

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Table 3 – Role of Legal Protectionititiitittiit ufCFLPQcbQaaCAPX )( 11

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Table 4 – Role of Legal Origin and Legal Protection

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ititiiitittiit ufCFLPLOQcbQaaCAPX )( 11

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Table 5 – Alternative Specifications

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Table 6 – Role of Equity-Dependenceititittiit ufCFbQaaCAPX 1

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Table 7 – Role of Legal Protectionand Equity-Dependence

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Table 8 – Robustness Testititiitittiit ufCFLPQcbQaaCAPX )( 11

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Conclusion Legal protection and the equity-financing

channel matter for the sensitivity of corporate investment to stock prices in an international setting.

Important implications for regulators and individual firms: better appreciate the role of legal protection on corporate investment behavior through equity-financing channel.

Overall, legal protection and equity dependence interact with each other, with the objective of attaining efficient allocation of capital to investment projects.