Legal Protection, Equity Dependence, and Corporate Investment

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.