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Legal Protection, Equity Dependence, and Corporate Investment

This research paper explores the relationship between legal protection, equity dependence, and the sensitivity of corporate investment to stock prices. It provides evidence from various countries and examines the role of the equity-financing channel in influencing managers' investment decisions.

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Legal Protection, Equity Dependence, and Corporate Investment

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  1. Legal Protection, Equity Dependence and Corporate Investment: Evidence from Around the World YUANTO KUSNADI City University of Hong Kong SHERIDAN TITMAN University of Texas at Austin & NBER K.C. JOHN WEI HKUST February 2009

  2. 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.

  3. Introduction • Learning hypothesis: • Stock prices contain may contain private information that managers do not know (eg: Dow and Gorton (1997); Subrahmanyam and Titman (1999)). • Financing markets are not a sideshow (Chen et al. (2007)). • Behavioral finance literature: • Stock markets may not be efficient, ie: there exists non-fundamental component in stock prices (mispricing). • Equity-financing channel argument.

  4. Introduction • Motivation: • Very little is known regarding the relationship between corporate investment and the stock market outside the U.S. • Few studies examine if cross-country differences in institutional characteristics (as a measure of private information) could determine firm-level corporate investment decisions. • Objectives and Contributions: • Examine the role of legal protection and equity dependence on the sensitivity of corporate investment to stock prices. • No previous study has empirically examined these issues simultaneously.

  5. Summary of Results • Positive relationship between legal protection of investors and investment-stock price sensitivity. • Investment-stock 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-stock price sensitivity is more pronounced for equity-dependent firms. • Therefore, both legal protection and equity dependence influence managers’ corporate investment decisions with respect to changes in stock prices.

  6. Related Literatures • Corporate investment and stock prices • 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. (2007): the stock market matters and affects real investment! • Chen et al. (2007) • Learning channel argument • Stein (1996); Baker et al. (2003) • Equity-financing channel argument

  7. 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.

  8. 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-stock 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.

  9. 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.

  10. 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): • 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.

  11. Data • Legal protection measures: • Anti-directors rights, private, and public enforcement (LLS, 2006). • 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

  12. Table 3 – Role of Legal Protection

  13. Table 4 – Sensitivity Analysis

  14. Table 5 – Role of Equity Dependence

  15. Table 7 – Role of Legal Protectionand Equity-Dependence

  16. 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.

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