CORPORATE INVESTMENT, FINANCING AND PAYOUT DECISIONS:

Transcription

1 CORPORATE INVESTMENT, FINANCING AND PAYOUT DECISIONS: EVIDENCE FROM UK-LISTED COMPANIES by QINGWEI MENG A hesis submied o he Universiy of Birmingham for he degree of DOCTOR OF PHILOSOPHY Deparmen of Accouning and Finance Birmingham Business School Universiy of Birmingham Sepember 2012

2 Universiy of Birmingham Research Archive e-heses reposiory This unpublished hesis/disseraion is copyrigh of he auhor and/or hird paries. The inellecual propery righs of he auhor or hird paries in respec of his work are as defined by The Copyrigh Designs and Paens Ac 1988 or as modified by any successor legislaion. Any use made of informaion conained in his hesis/disseraion mus be in accordance wih ha legislaion and mus be properly acknowledged. Furher disribuion or reproducion in any forma is prohibied wihou he permission of he copyrigh holder.

3 Absrac ABSTRACT The research repored in his docoral hesis aims o conribue o he corporae finance lieraure by focusing on he inerdependence of corporae invesmen, financing and payou decisions of UK-lised companies, wihin he period The hesis consiss of six chapers. Afer he inroducory chaper, Chaper 2 criically reviews he exising heoreical and empirical lieraure on corporae invesmen, financing and payou policies, from which several promising research ideas are idenified. Chaper 3 invesigaes he ineracions among he hree corporae decisions. One of he key findings is ha he hree corporae decisions are likely o be joinly deermined in he presence of financial consrains. The resuls also sugges ha he effec of uncerainy on corporae invesmen is significanly posiive, bu he effec on dividend payou is significanly negaive. Chaper 4 explores he influence of managerial confidence and economic senimen on he se of joinly deermined corporae decisions. An imporan finding is ha he sae of confidence a aggregae levels has significanly posiive effecs on boh real invesmen and deb financing decisions. Chaper 5 discriminaes concepually and evaluaes empirically weny alernaive measures of corporae invesmen used in he exising lieraure. I is found ha conclusions drawn from empirical analyses are likely o be sensiive o he choice of corporae invesmen measures, indicaing ha he measuremen of corporae invesmen behaviour maers. The key findings of he hesis are summarised in he conclusion chaper, alongside some promising ideas for furher research. i

4 Dedicaion DEDICATION To my dear parens for all of your love and suppor ii

5 Acknowledgemens ACKNOWLEDGEMENTS This hesis has been made possible hrough he suppor and assisance of many individuals and organisaions. I herefore wish o acknowledge he following in producing his hesis. My greaes inellecual indebedness is o Professor Vicor Murinde and Dr. Ping Wang, my supervisor and co-supervisor, for heir excellen guidance, valuable advice and coninuous suppor hroughou my PhD programme. They have provided me wih helpful suggesions, no only for my research work, bu also for my career developmen. My sincere graiude also goes o Professor Chrisopher J. Green and Dr. Paul Cox, my exernal and inernal examiners, for offering criical and consrucive commens on he final draf of his hesis. I wish o express my sincere graiude o Birmingham Business School and he Graduae School of he Universiy of Birmingham for providing me wih valuable academic suppor during he course of my sudy, and for sponsoring me o presen my research papers a he 18 h Global Finance Conference in Bangkok, Thailand; he 18 h Mulinaional Finance Conference in Rome, Ialy; he 8 h Applied Financial Economics Conference in Samos, Greece; he 19 h Global Finance Conference in Chicago, USA; and he 19 h Mulinaional Finance Conference in Krakow, Poland. I would like o exend my graiude o he discussans and paricipans a he Global Finance Conference 2011 and 2012, Mulinaional Finance Conference 2011 and 2012, Applied Financial Economics Conference 2011, Midlands Regional Docoral Colloquium iii

6 Acknowledgemens 2010 and 2011, ESRC seminar 2009 as well as research seminars held a he African Developmen Bank and Birmingham Business School for heir valuable commens and consrucive suggesions on he previous versions of he papers presened in his hesis. Special hanks o he Global Finance Associaion for awarding he paper eniled Corporae invesmen, financing and payou decisions under financial consrains and uncerainy: evidence from UK panel daa he Bes Paper Award; he College of Social Science of he Universiy of Birmingham for awarding he above paper he Bes Docoral Research Paper Award; and he Midlands Docoral Colloquium for awarding he paper eniled The measuremen of corporae invesmen maers: evidence from UK panel daa he Bes Paper Award. The papers menioned above are based on earlier versions of Chapers 3 and 5 presened in his hesis respecively. I am graeful o he academic saff and my fellow PhD sudens in he Corporae Finance Research Group a Birmingham Business School who have also commened on my work, especially Professor Rober Cressy and Dr. Hisham Farag. Furhermore, I wish o hank all my colleagues and friends who helped me, moivaed me, and made my say in he UK enjoyable and unforgeable. Finally, and mos imporanly, I am deeply indebed o my dear parens, Xianhua Meng and Yuzhen Shi, for heir uncondiional suppor wih love and paience over he years. This sudy would no have reached is conclusion wihou heir encouragemen and inspiraion. iv

7 Table of Conens TABLE OF CONTENTS Absrac Dedicaion Acknowledgemens Lis of Tables Lis of Figures Lis of Appendices i ii iii x xii xiii Chaper 1: Inroducion Background and moivaion Daa and mehodology Srucure and scope of he hesis 9 Chaper 2: Lieraure Review Inroducion Corporae decision heories Corporae invesmen heories Corporae financing heories Dividend payou heories Simulaneiy of corporae decisions Insiuional approach Flow-of-funds framework for corporae behaviour Informaion approach Tax approach Agency approach Corporae decisions under uncerainy 63 v

8 Table of Conens Corporae invesmen decision and uncerainy Corporae financing decision and uncerainy Corporae payou decision and uncerainy Corporae decisions and managerial confidence Modern corporae finance versus behavioural corporae finance Corporae invesmen decision and managerial confidence Corporae financing decision and managerial confidence Corporae payou decision and managerial confidence Conclusion and promising research ideas Conclusion Promising research ideas 95 Chaper 3: Corporae Decisions, Financial Consrains and Uncerainy Inroducion Empirical proxies for uncerainy Oupu volailiy Inpu volailiy Profi volailiy Sock reurns volailiy Macroeconomic volailiy An informaion asymmery-based flow-of-funds framework for corporae behaviour Modelling corporae invesmen, financing and payou behaviour Corporae invesmen equaion Deb financing equaion Dividend payou equaion Daa and preliminary analysis Daa and measuremen 134 vi

9 Table of Conens Preliminary diagnosic ess Empirical resuls and implicaions for corporae behaviour Single equaion analyses Simulaneous equaions analyses Long-run soluion o he simulaneous equaions sysem Robusness ess and furher evidence Robusness ess and resuls Furher evidence on he simulaneiy of corporae decisions Concluding remarks 186 Chaper 4: Corporae Decisions, Managerial Confidence and Economic Senimen Inroducion Measures of managerial confidence and economic senimen Secor-specific managerial confidence indicaors Economic senimen indicaors Modelling corporae behavioural equaions Corporae behavioural equaions wih proxy for he sae of confidence Corporae behavioural equaions wih confidence and uncerainy variables Daa and preliminary analysis Empirical resuls and implicaions for corporae behaviour Simulaneous analyses wih proxy for he sae of confidence Simulaneous analyses wih confidence and uncerainy variables Robusness ess and furher evidence Robusness ess and resuls Furher evidence on he influence of managerial confidence on corporae behaviour Concluding remarks 262 vii

10 Table of Conens Chaper 5: The Measuremen of Corporae Invesmen Behaviour Maers Inroducion Empirical measures of corporae invesmen behaviour Cash based versus accrual based corporae invesmen measures Gross versus ne corporae invesmen measures Book versus replacemen values of capial sock Conemporaneous versus lagged proxies for capial sock Conclusion Developmen of hypoheses Hypoheses regarding wheher he measuremen of invesmen maers Hypoheses regarding he volailiy of invesmen measures Hypoheses regarding he informaion conen of invesmen measures Daa and preliminary analysis Daa and measuremen Summary saisics Correlaion coefficien analysis A simple regression of Tobin s Q model of invesmen Empirical procedures Empirical resuls Robusness ess and resuls Conclusion Trend analysis Empirical procedures Empirical resuls Robusness ess and resuls Conclusion Informaion conen analysis 339 viii

11 Table of Conens Incremenal and relaive informaion conen Empirical procedures Empirical resuls Robusness ess and resuls Conclusion Concluding remarks 354 Chaper 6: Conclusion Summary Key empirical findings and conclusions Simulaneous deerminaion of corporae decisions Corporae decisions under uncerainy Corporae decisions and he sae of confidence Measuremen of corporae invesmen behaviour Main conribuions o he exising lieraure Pracical implicaions of he findings Implicaions for corporae managers Implicaions for public policy makers Implicaions for invesors Limiaions of he research Promising ideas for furher research 404 References 408 ix

12 Lis of Appendices LIST OF TABLES Table 3.1: Endogenous corporae decision variables and hypohesised ineracions under he flow-of-funds framework for corporae behaviour 129 Table 3.2: Descripion of main variables used in Chaper Table 3.3: Descripive saisics for main variables used in Chaper Table 3.4: Correlaion coefficien marix of variables used in Chaper Table 3.5: Tess for equaliy of uses and sources of funds 145 Table 3.6: Endogeneiy ess for corporae decision variables 147 Table 3.7: Endogeneiy es for cash flow variable 149 Table 3.8: Sysem-GMM esimaion resuls for corporae invesmen equaion wih uncerainy 155 Table 3.9: Sysem-GMM esimaion resuls for corporae financing equaion wih uncerainy 160 Table 3.10: Sysem-GMM esimaion resuls for corporae dividend equaion wih uncerainy 164 Table 3.11: 3SLS esimaion resuls for invesmen, financing and payou equaions wih uncerainy 169 Table 3.12: Long-run soluion o he simulaneous equaions sysem 176 Table 3.13: 3SLS esimaion resuls for corporae behavioural equaions wih uncerainy using subsamples 182 Table 4.1: Descripive saisics for secor-specific confidence and economic senimen indicaors 219 Table 4.2: Correlaion coefficien marix of he UK and EU secor-specific confidence and economic senimen indicaors 221 Table 4.3: Descripion of main variables used in Chaper x

13 Lis of Appendices Table 4.4: Descripive saisics for main variables used in Chaper Table 4.5: Correlaion coefficien marix of variables used in Chaper Table 4.6: 3SLS esimaion resuls for corporae behavioural equaions wih secor-specific managerial confidence 239 Table 4.7: 3SLS esimaion resuls for corporae behavioural equaions wih economic senimen 243 Table 4.8: 3SLS esimaion resuls for corporae behavioural equaions wih company-level uncerainy and secor-specific managerial confidence 247 Table 4.9: 3SLS esimaion resuls for corporae behavioural equaions wih company-level uncerainy and economic senimen 249 Table 4.10: 3SLS esimaion resuls for corporae behavioural equaions wih secor-specific managerial confidence ineraced wih secor dummies 256 Table 4.11: 3SLS esimaion resuls for corporae behavioural equaions wih company-level uncerainy and secor-specific managerial confidence ineraced wih secor dummies 259 Table 5.1: Corporae invesmen measures and represenaive recen sudies 300 Table 5.2: Summary saisics for corporae invesmen measures examined in Chaper Table 5.3: Pearson correlaion coefficiens of alernaive corporae invesmen measures 316 Table 5.4: Sysem-GMM esimaion resuls for Tobin s Q model of corporae invesmen 321 Table 5.5: Sysem-GMM esimaion resuls for he rend regression of corporae invesmen measures 331 Table 5.6: Coefficiens of variaion of he roo mean square error of he corporae invesmen measures 335 Table 5.7: Sysem-GMM esimaion resuls for he regression of sock reurns on unexpeced earnings and unexpeced corporae invesmen 347 Table 5.8: Volailiy-informaion conen marix for corporae invesmen measures 353 xi

14 Lis of Appendices LIST OF FIGURES Figure 1.1: Flowchar for he research mehodology of his sudy 6 Figure 4.1: Time series plo of UK versus EU manufacuring secor confidence indicaors 211 Figure 4.2: Time series plo of UK versus EU services secor confidence indicaors 211 Figure 4.3: Time series plo of UK versus EU consumer confidence indicaors 212 Figure 4.4: Time series plo of UK versus EU reail rade secor confidence indicaors 212 Figure 4.5: Time series plo of UK versus EU consrucion secor confidence indicaors 213 Figure 4.6: Time series plo of UK versus EU economic senimen indicaors 217 Figure 5.1: Logical relaion beween incremenal and relaive informaion conen of wo variables 341 xii

15 Lis of Appendices LIST OF APPENDICES Appendix 2.A: Corporae invesmen heories and represenaive recen empirical evidence 99 Appendix 2.B: Capial srucure heories and represenaive recen empirical evidence 102 Appendix 2.C: Dividend policy heories and represenaive recen empirical evidence 106 Appendix 2.D: Mehodologies and findings of seleced lieraure on simulaneiy of corporae decisions 110 Appendix 3.A: Key findings from Chaper 3 versus findings from prior research 188 Appendix 3.B: 2SLS esimaion resuls for invesmen, financing and payou equaions wih uncerainy 193 Appendix 3.C: 3SLS esimaion resuls for invesmen, financing and payou equaions wihou uncerainy 195 Appendix 3.D: 3SLS esimaion resuls for invesmen, financing and payou equaions wih alernaive measure of uncerainy UNC2 197 Appendix 3.E: 3SLS esimaion resuls for invesmen, financing and payou equaions wih alernaive measure of uncerainy UNC3 199 Appendix 4.A: Sample sizes of he Join Harmonised EU Business and Consumer Surveys 264 Appendix 4.B: EU Programme of Business and Consumer Surveys 265 Appendix 4.C: 3SLS esimaion resuls for corporae behavioural equaions wih secor-specific managerial confidence a year end 272 Appendix 4.D: 3SLS esimaion resuls for corporae behavioural equaions wih economic senimen a year end 274 Appendix 4.E: 3SLS esimaion resuls for corporae behavioural equaions wih changes in economic senimen 276 xiii

16 Lis of Appendices Appendix 4.F: 2SLS esimaion resuls for corporae behavioural equaions wih secor-specific managerial confidence 278 Appendix 4.G: 2SLS esimaion resuls for corporae behavioural equaions wih economic senimen 280 Appendix 5.A: Perpeual invenory mehod for esimaing he replacemen value of capial sock 358 Appendix 5.B: Mean-comparison es resuls for alernaive corporae invesmen measures 359 Appendix 5.C: Time series plo of annual mean values of corporae invesmen measures 361 Appendix 5.D: Spearman s rank correlaion coefficiens of alernaive corporae invesmen measures 364 Appendix 5.E: Difference-GMM esimaion resuls for Tobin s Q model of corporae invesmen 366 Appendix 5.F: Sysem-GMM esimaion resuls for Tobin s Q model of corporae invesmen wihou dynamic srucure 369 Appendix 5.G: Sysem-GMM esimaion resuls for Tobin s Q model of corporae invesmen wih alernaive measure of Q 372 Appendix 5.H: Rankings of he corporae invesmen measures based on an alernaive measure of volailiy 375 Appendix 5.I: Difference-GMM esimaion resuls for he rend regression of corporae invesmen measures 376 Appendix 5.J: Coefficiens of variaion of he roo mean square error based on difference-gmm esimaion resuls 379 Appendix 5.K: Fixed effec esimaion resuls for he regressions of sock reurns on unexpeced earnings and unexpeced corporae invesmen 380 Appendix 5.L: Sysem-GMM esimaion resuls for he regressions of sock reurns on unexpeced earnings and alernaive measure of unexpeced corporae invesmen 382 xiv

17 Chaper 1: Inroducion CHAPTER 1 INTRODUCTION 1.1 Background and moivaion Corporae invesmen, financing and payou choices are known as he rilogy of corporae decisions (see Wang, 2010), and are believed o have significan influence on corporae performance. They have araced grea aenion in he exising lieraure (see, for example, Denis and Osobov, 2008; Almeida and Campello, 2007; Frank and Goyal, 2003; Baker e al., 2002; among many ohers). Companies use inernal and exernal funds o finance heir invesmen projecs, in an aemp o maximise heir company value and hus shareholders wealh. Inernal funds are chiefly represened by reained earnings and non-cash expenses; and exernal funds mainly refer o he proceeds from issuing new deb and new equiy. Managers, herefore, have o make boh real (i.e. non-financial) and financial decisions. The real decisions are concerned wih he opimal level of capial invesmen; while financial decisions are concerned wih how o finance he desired invesmen, which involves he appraisal of wo financial choices. One is dividend payou choice, i.e. how much inernally generaed funds should be paid ou o shareholders as dividends which oherwise could be re-invesed in he business. The oher is exernal financing choice, i.e. how much exernal funds does a company need o raise from ouside capial markes for is invesmen. Alhough much effor has been devoed o invesigaing he corporae behaviour of 1

18 Chaper 1: Inroducion companies, he hree corporae decisions are ypically discussed separaely and rouinely examined in isolaion raher han alogeher. Indeed, he seminal works by Modigliani and Miller (1958) and Miller and Modigliani (1961) posi separaely he invesmen separaion principle, capial srucure irrelevance heorem and dividend irrelevance heorem (hereafer he Modigliani-Miller heorems). The Modigliani-Miller heorems demonsrae ha inernal and exernal funds for a company are perfec subsiues in a perfec marke environmen, and hence he company s opimal level of invesmen should be deermined solely by is real consideraions and oally independen of is financial decisions. Boh capial srucure and dividend payou choices, hus, should have no impac on company value, and be irrelevan o shareholders wealh, suggesing no inerdependencies among he se of corporae decisions wihin a perfec marke environmen. As a resul, each of he hree corporae decisions has been widely and inensively scruinised in he exising corporae finance lieraure, bu we know lile abou he ineracions ha may exis among hem. Prior research, however, has provided reasons and evidence ha financial consrains in he real world, such as insufficien availabiliy of inernal funds and limied access o new exernal funds, may hamper companies abiliy o inves efficienly (see, for example, Fazzari e al., 1988; and Guariglia, 2008). I is rue ha in pracice he corporae decisions are relaed hrough he accouning ideniy, in ha sources of funds mus equal uses of funds. So when a company adjuss any one policy, he oher policies may also be affeced. Therefore, companies should consider heir invesmen decisions alongside heir fund-raising choices. 2

19 Chaper 1: Inroducion Alhough no consensus has been reached, an imporan implicaion is ha corporae invesmen, financing and payou decisions are likely o be inerdependen upon one anoher and joinly deermined by managemen. The single equaion frameworks used by prior research wihou explicily accouning for he inerdependence among corporae decisions may be misspecified, which poenially leads o incomplee and biased resuls. A simulaneous equaions framework, herefore, is likely o provide greaer insigh ino he iner-relaionships ha may exis among he se of corporae decisions, improving our knowledge of corporae decision-making processes in he real world. I is worh highlighing ha, by referring o he simulaneous deerminaion of corporae decisions hroughou he hesis, we are by no means arguing ha corporae decisions are necessarily made a he same ime, bu raher ha hey are likely o be execued on simulaneously so ha he oucomes can be observed via a simulaneous approach. Recen lieraure ha seeks o explore he deerminans of corporae invesmen behaviour has highlighed he imporance of uncerainy associaed wih companies fuure prospecs, even hough he invesmen-uncerainy relaionship remains heoreically ambiguous and empirically inconclusive (see, for example, Carruh e al., 2000; Lensink and Murinde, 2006; and Baum e al., 2008). However, he poenial effecs of uncerainy on corporae financing and payou decisions have received lile aenion. Given he fac ha all corporae decisions are made on he basis of incomplee informaion and a company s fuure cash flows are likely o be uncerain, i is reasonable o argue ha he degree of uncerainy 3

20 Chaper 1: Inroducion maers in boh corporae financing and payou decisions as well. If his is rue, uncerainy may influence invesmen, no only on is own, bu also hrough is effecs on financing and payou choices. Prior research on corporae invesmen under uncerainy ha ignore he roles played by financing and payou choices should be criically reviewed, since hey may generae misleading resuls and lead o inappropriae inferences. I is, herefore, more plausible o model corporae invesmen, financing and payou decisions simulaneously, and o invesigae he effec of uncerainy on he se of corporae decisions sysemaically. Moreover, recen developmens sugges ha behavioural finance plays an imporan role in explaining aspecs of finance ha radiional finance lieraure has failed o explain. Behavioural finance lieraure replaces he radiional assumpion of broad raionaliy wih a poenially more realisic assumpion ha agens behaviours are less han fully raional. The assumpion of less han full raionaliy finds srong suppor from a large body of psychological lieraure (see, for example, Gilovich e al., 2002). The behavioural finance approach is now commonly used in asse pricing lieraure, in which invesors are assumed o be less han fully raional. Corporae finance lieraure, however, rarely relaxes he assumpion ha managers are fully raional. Alhough he heoreical framework in his emerging area has no been firmly esablished and he empirical evidence is sill relaively rare (see Baker e al., 2006), i is plausible o hypohesise ha he less han fully raional manager approach o behavioural corporae finance has he poenial o explain a wide range of paerns in companies invesmen, financing and payou choices. This hesis, herefore, also exends he 4

21 Chaper 1: Inroducion exising corporae finance lieraure by incorporaing he sae of managerial confidence and economic senimen ino corporae behavioural models in an aemp o provide new insighs ino he influence of managers psychological bias on aspecs of corporae behaviour. 1.2 Daa and mehodology The research mehodology adoped by his sudy is described in Figure 1.1, using a simple flowchar. I sars wih a comprehensive and criical review of he exising lieraure, which is no only helpful in undersanding he relevan conex of his sudy, bu also useful for idenifying he poenial gaps in he previous sudies from which a number of research ideas are proposed. The promising research ideas are used o develop esable hypoheses and o formulae empirical models. The daa used in his sudy are colleced from differen sources, which are mainly secondary and hus available elecronically hrough financial and economic informaion providers. Specifically, accouning and financial daa for he companies lised on he London Sock Exchange (LSE) wihin he period from 1999 o 2008 are rerieved from he Worldscope daabase via Thomson One Banker Analyics. Sock price daa for he same bach of companies over he same period of ime are colleced from he DaaSream daabase. The indicaors for managerial confidence and economic senimen are publicly available from he European Commission Economic Daabase. Worldscope is chosen as he principal daa source since i is he mos comprehensive web-based daabase covering accouning and financial informaion for companies from 130 exchanges, including he LSE lised companies. 5

22 Chaper 1: Inroducion Figure 1.1: Flowchar for he research mehodology of his sudy Lieraure review Research ideas No Is he research idea promising? Yes Developmen of hypohesis / Model specificaion Daa collecion / Variable consrucion Model esimaion / Tesing No Is he model saisically adequae? Yes Resuls / Inerpreaion Conclusion / Implicaion Ideas for furher research 6

23 Chaper 1: Inroducion A he daa collecion sage, as many companies, years and iems as possible are colleced o form our daase in order o preven he need for exra daa collecion a laer sages. The iniial daase has more han 30,000,000 daa enries. There are, however, some variaions among he sample sizes used in differen empirical works presened in his hesis, depending on he objecives of he sudies, he specificaions of he models as well as he esimaion echniques adoped. A deailed descripion of he sampling procedures employed o consruc he final samples is given in each of he empirical chapers. UK-lised companies are chosen as he sample for his hesis because i is argued ha financial consrains on corporae invesmen are relaively more severe in he more marke-oriened UK financial sysem han in he coninenal European financial sysem (see, for example, Bond e al., 2003; and Seifer and Gonenc, 2008). Bond e al. (2003) indicae ha, compared wih he coninenal European financial marke, he marke-oriened financial sysem in he UK perform less well in channelling invesmen funds o companies wih profiable invesmen opporuniies because of he arm s-lengh relaion beween companies and suppliers of finance. The marke-oriened financial sysem in he UK hus may give rise o financial consrains for he UK-lised companies. Moreover, Seifer and Gonenc (2008) poin ou ha he ownership of he UK-lised companies is considerably dispersed as compared o companies in oher markes. Because of he relaively widespread ownership of sock, invesors in he UK face more severe problems of informaion asymmery, which may also give rise o financial consrains. Therefore, he ineracions among corporae invesmen, 7

24 Chaper 1: Inroducion financing and payou decisions are likely o be more pronounced for he UK-lised companies which end o be characerised by severe financial consrains. Besides, his sudy focus on he corporae decisions made by he UK-lised companies over he period which allow us o sidesep he daa breaks ha characerise he period The daase is organised as a panel which has boh cross-company and ime-series dimensions. The pooling of company-year observaions provides a more informaive daase which enables us o ackle he complexiy of corporae decision-making procedures by relaxing he assumpions ha are implicily made in pure cross-secional or pure ime-series analysis (see, for example, Balagi, 2008; and Brooks, 2008). Therefore, he rich srucure makes he panel daase inuiively more preferable han pure cross-secional and pure ime-series daa in he conex of empirical corporae finance research. The empirical models formulaed in his hesis are esimaed using a number of esimaion echniques for panel daa, including fixed effec, random effec, firs-difference generalised mehod of momens (difference-gmm), sysem generalised mehod of momens (sysem-gmm), wo-sage leas squares (2SLS) and hree-sage leas squares (3SLS) esimaions. The choice of esimaion mehods largely depends on he model specificaion, he sampling procedure and he resuls from saisical ess. Diagnosic ess and robusness checks are also carried ou o saisically evaluae he esimaion resuls. If a model is no saisically adequae, eiher he model will be reformulaed or a differen esimaion echnique will be used. The process of building a saisically adequae and robus model, herefore, is an 8

25 Chaper 1: Inroducion ieraive one, as illusraed in Figure 1.1. The empirical resuls obained from esimaing saisically adequae models are inerpreed wih reference o heoreical predicions. Overall, he main research mehodology adoped by his hesis is empirical. The hesis as a whole is srucured following he seps described in Figure 1.1. Besides his, he empirical papers presened in Chapers 3, 4 and 5 are also srucured in such a way as o ensure a good undersanding of he exising lieraure, promising research ideas, solid heoreical frameworks, a sufficienly large daase, appropriae economeric echniques, esing for robusness of empirical resuls, credible inerpreaions, and hus reliable findings and conclusions. A deailed mehodology is provided in each of he empirical chapers. 1.3 Srucure and scope of he hesis The hesis consiss of six chapers, including an inroducion, a lieraure review chaper, hree sand-alone empirical chapers and a conclusion. The remainder of he hesis is srucured as follows. Chaper 2 criically reviews he exising lieraure, boh heoreical and empirical, on corporae invesmen, financing and payou policies. Corporae finance heories abou he hree key corporae decisions are briefly reviewed respecively, ogeher wih recen empirical evidence, in order o explore he curren sae of knowledge on aspecs of corporae behaviour. More imporanly, some prior sudies aemp o examine how various fricions in he real world may drive linkages among corporae invesmen, financing and payou decisions. The mechanisms hrough which he se of corporae decisions may affec one anoher are explored 9

26 Chaper 1: Inroducion in deail. Furhermore, since uncerainy has been idenified as a key deerminan of corporae invesmen, Chaper 2 comprehensively reviews lieraure on he effec of uncerainy on corporae invesmen decisions as well as is poenial effecs on corporae financing and payou decisions. In addiion, following he recen argumen ha managers psychological bias may explain a wide range of paerns in corporae behaviour ha radiional corporae finance lieraure has failed o explain, Chaper 2 also reviews he small bu growing srand of lieraure on behavioural corporae finance. Based on he lieraure reviewed in Chaper 2, several promising research ideas are proposed, aiming o fill he criical lacunae idenified in he exising corporae finance lieraure. Chaper 3 presens he firs empirical work. I invesigaes he ineracions among corporae invesmen, financing and payou decisions under financial consrains and uncerainy, using a large panel of UK-lised companies. We model hese corporae decisions wihin a simulaneous equaions sysem which explicily allows for conemporaneous inerdependence among hem, as implied by he informaion asymmery-based flow-of-funds framework for corporae behaviour. I is found ha capial invesmen and dividend payou, as compeing uses of funds, are negaively inerrelaed, bu boh are posiively relaed o he ne amoun of new deb issued, which may imply join deerminaion of corporae decisions under financial consrains. We also offer he firs aemp o examine simulaneously he effecs of uncerainy on he hree corporae decisions. The resuls show ha he effec of uncerainy on corporae invesmen is significan and posiive, while he effec on dividend payous is 10

27 Chaper 1: Inroducion significan and negaive. Furhermore, he resuls sugges ha financial consrains may inensify simulaneiy among corporae decisions, and reduce managerial flexibiliy o respond o uncerainy. Chaper 4 presens he second empirical work. I exends he work presened in Chaper 3 by aking ino accoun he role of he sae of confidence in he deerminaion of corporae decisions. The relaions beween corporae decisions and he sae of confidence are examined wihin he simulaneous equaions sysem formulaed in Chaper 3. I is found ha he sae of confidence a aggregae level, as proxied by UK or EU secor-specific managerial confidence indicaors or overall economic senimen indicaors, has significanly posiive effecs on companies real invesmen and deb financing decisions. The significan effecs of he sae of confidence on invesmen and financing decisions persis even afer conrolling for company idiosyncraic uncerainy and oher company-specific fundamenal characerisics. However, corporae payou decisions are mainly affeced by company idiosyncraic uncerainy raher han confidence a secor level or senimen a economy level. Besides, he resuls also show ha, compared wih he companies in he oher secors, UK-lised companies in he services secor behave more aggressively when he managerial confidence or economic senimen is high. Specifically, hey inves in capial sock more inensively, use deb financing more heavily, and cu dividends more decisively when heir managers are confiden. Chaper 4 conribues o he small bu growing lieraure on behavioural corporae finance, providing evidence ha managers psychological bias plays an imporan role in he 11

28 Chaper 1: Inroducion deerminaion of corporae decisions. Chaper 5 presens he hird empirical work. The survey of corporae finance lieraure shows ha use of corporae invesmen o capial sock raio as a measure of corporae invesmen behaviour has been common pracice in empirical analyses. Alhough he corporae invesmen measures used in he lieraure seem, a firs sigh, o be very similarly specified, hey in fac vary in erms of he numeraor and he denominaor, i.e. how invesmen spending and capial sock are empirically measured. However, here is no lieraure ha provides a comparison among he various versions of he corporae invesmen raios, and hus we know lile abou how differenly hese corporae invesmen measures perform in empirical analyses. As a resul, a claim has been implicily made ha he differen measures of corporae invesmen can always yield equivalen resuls in corporae invesmen research. The purpose of Chaper 5, herefore, is o concepually discriminae and saisically evaluae weny alernaive measures of corporae invesmen raios which have been idenified in he exising lieraure. Simple saisical and economeric procedures are uilised o es he sensiiviy of he conclusions drawn from empirical analyses o choice of corporae invesmen measures. I is found ha corporae invesmen measures wih differen specificaions are no uniformly posiively correlaed wih one anoher. Significanly negaive correlaions are also observed among he alernaive measures, which appear surprising, since hey are supposed o measure he invesmen behaviour of he same bach of companies over he same period of ime. A simple regression of he Tobin s Q model clearly shows ha he 12

29 Chaper 1: Inroducion choice of corporae invesmen measures, o a considerable exen, influences he conclusions drawn from empirical analyses. Furhermore, he relaive performances of he alernaive corporae invesmen measures, in erms of volailiy and informaion conen, are empirically evaluaed. Empirical resuls sugges ha gross invesmen measures are less volaile around heir respecive rends and hus are more predicable compared wih ne invesmen measures, while cash based invesmen measures conain greaer value relevan informaion han heir accrual based counerpars. Accordingly, cash based gross invesmen measures, which conain relaively less noise and greaer value relevan informaion, are recommended o researchers for fuure sudies, if hey have o make a muually exclusive choice among he alernaives wihou any paricular preference. Chaper 6 concludes his hesis by recapping he research quesions, summarising he key findings, highlighing he main conribuions, discussing he broad implicaions and acknowledging he limiaions. A number of promising ideas for fuure research are also proposed in Chaper 6. 13

30 Chaper 2: Lieraure Review CHAPTER 2 LITERATURE REVIEW 2.1 Inroducion Invesmen, financing and payou choices are he hree imporan corporae decisions ha have araced much aenion in he lieraure for more han half cenury (see, for example, Denis and Osobov, 2008; Almeida and Campello, 2007; Frank and Goyal, 2003; and Baker e al., 2002). The seminal works by Modigliani and Miller (1958) and Miller and Modigliani (1961), i.e. he Modigliani-Miller heorems, show ha, in a perfec marke environmen, inernal and exernal funds are perfec subsiues for companies o finance heir invesmen, and hence he opimal level of invesmen should be solely deermined by he real consideraions and oally independen of he financial decisions. 1 Since he seminal works by Modigliani and Miller, researchers have ried o explain how real world complicaions aler perfec and efficien capial marke condiions, and how marke imperfecions make corporae financing and payou choices relevan o invesmen decisions and company value. By relaxing Modigliani-Miller s assumpions and inroducing 1 The Modigliani-Miller heorems are generally considered as a cornersone of modern corporae finance, so we shall no go ino he deails of he seminal works. Suffice i o say here ha Modigliani-Miller s assumpions include he exisence of risk class (i.e. each company belongs o a risk class), neural axes (i.e. all ypes of ax payer and all sources of income are axed a he same rae), no capial marke fricions (i.e. no ransacion coss, no bankrupcy coss, no floaion coss and no asse rade resricions), symmerical access o credi markes (i.e. he same borrowing and lending rae for companies and invesors); corporae financial policy conains no informaion (i.e. financial choices canno be used o convey any signal abou a company s value o invesors), ec. 14

31 Chaper 2: Lieraure Review marke imperfecions, corporae finance research has inensively scruinised each of he hree corporae decisions. Alhough much effor has been devoed o invesigaing he corporae behaviour of companies, hese hree corporae decisions are ypically discussed separaely and rouinely examined in isolaion. For example, empirical invesigaions of corporae invesmen decisions commonly uilise a single equaion framework in which a corporae invesmen measure is regressed on a se of exogenous explanaory variables, wihou explicily accouning for he inerdependence of various oher policies, such as financing and payou choices. Similar approaches are also used o invesigae corporae financing and payou decisions. In pracice, however, corporae decision-making is a complex process, in which he decisions made by one deparmen are likely o be affeced by hose made by ohers (Mueller, 1967). As argued by Fazzari e al. (1988), financial consrains, such as insufficien availabiliy of inernal finance and limied access o exernal finance, may hamper companies abiliy o inves efficienly. Under such condiions, companies have o consider heir fund-raising choices alongside invesmen decisions; ha is, if any one policy is adjused, oher polices mus also be adjused accordingly (Gachev e al., 2010). However, our knowledge abou he poenial ineracions among he corporae decisions is limied by he single equaion framework currenly used in he lieraure, which is unable o capure he simulaneous deerminaion of corporae decisions and fails o provide a complee view of corporae behaviour. I should be borne in mind ha he simulaneous deerminaion corporae decision refers o he execuion, or oucome, of he se of corporae decisions raher han he 15

32 Chaper 2: Lieraure Review acual decision-making process. Convenional lieraure on corporae finance has also been criicised for overlooking he effecs of uncerainy on companies real and financial behaviours. Recen sudies ha seek o explore he deerminans of corporae invesmen have highlighed he imporance of uncerainy associaed wih companies prospecs (see, for example, Baum e al., 2008; Lensink and Murinde, 2006; and Carruh e al., 2000). Several channels hrough which uncerainy may influence invesmen have been idenified and examined. Noneheless, he relaionship beween invesmen and uncerainy remains heoreically ambiguous and empirically inconclusive. Compared wih corporae invesmen decisions, he imporance of uncerainy in financing and payou decisions has received lile aenion, and consequenly he influence of uncerainy on invesmen hrough is effecs on financing and payou choices has also been largely ignored. The omission of relevan informaion in examining he effec of uncerainy on corporae invesmen is likely o generae misleading resuls and lead o inappropriae inferences, casing doub on he conclusions drawn from he exiing lieraure on he invesmen-uncerainy relaionship. More recenly, behaviour finance has begun o play an imporan role in explaining aspecs of finance ha radiional finance lieraure has failed o explain. Behavioural finance lieraure replaces he radiional assumpion of broad raionaliy wih a poenially more realisic behavioural assumpion ha agens behaviours are less han fully raional, i.e. hey may have behavioural biases (Baker e al., 2006). Prior research in his area has mainly 16

33 Chaper 2: Lieraure Review focused on he influence of invesors psychological bias, by adoping he less han fully raional invesor approach o behavioural corporae finance. However, i is argued ha managers psychological bias may also have a subsanial impac on corporae decisions (see, for example, Malmendier e al., 2011; Oliver and Mefeh, 2010; Hackbarh, 2008; and Heaon, 2002). In paricular, managers upward bias owards fuure company performance may generae overinvesmen, underinvesmen and pecking order financing behaviours hrough differen mechanisms. Alhough he heoreical framework in his emerging area has no been firmly esablished and he empirical evidence is sill relaively rare, he exising lieraure shows ha he less han fully raional manager approach has he poenial o explain a wide range of paerns in companies invesmen, financing and payou choices which convenional corporae finance lieraure has failed o explain. The remainder of his chaper proceeds as follows. Secion 2.2 briefly reviews mainsream corporae finance heories on invesmen, financing and payou decisions respecively, alongside heir empirical evidence. Secion 2.3 explores he possible channels hrough which he hree corporae decisions may be inerdependen upon one anoher and hus joinly deermined by managemen. Secion 2.4 surveys boh heoreical and empirical sudies on he effecs of uncerainy on invesmen decisions as well as on he financial decisions of companies. Secion 2.5 focuses on he behavioural corporae finance lieraure and he relaionships beween managerial confidence and corporae decisions. Concluding remarks as well as promising research ideas are offered in Secion

34 Chaper 2: Lieraure Review 2.2 Corporae decision heories Corporae invesmen heories Corporae invesmen decision is one of he fundamenal decisions made by individual companies o risk heir funds, in he hope of producing sreams of revenue in he fuure. The bes-known mehod of deermining wheher an invesmen should be underaken is he sandard ne presen value (NPV) rule. Is principle is fairly simple, ha is, discoun boh expeced fuure cash inflow and ouflow of a projec back o heir presen value a a specific discoun rae, and hen sum hem up o obain he NPV of he projec. All projecs wih posiive NPV would add value o shareholders wealh and should be acceped, while all projecs wih negaive NPV would damage company value and should be rejeced. The NPV rule, on he one hand, has been widely used hroughou he business world. Graham and Harvey (2001) repor ha 74.9% of he Chief Financial Officers (CFOs) surveyed rely heavily on his echnique for evaluaing invesmen projecs. One he oher hand, i has long been acknowledged ha he applicaion of he NPV rule in capial invesmen pracices is no wihou criique. As noed in Dixi and Pindyck (1994), discoun raes se by companies o evaluae invesmen opporuniies are ypically hree or four imes he cos of capial. More recenly, Ow-Yong and Murinde (2009) survey a sample of 159 UK non-financial companies lised on he London Sock Exchange. They find ha a heory-pracice gap sill exiss in erms of he non-usage of discouned cash flow echniques. Arnold and Hazopoulos (2000) argue ha he heory-pracice gap in capial budgeing is 18

35 Chaper 2: Lieraure Review parly due o he impracical assumpions underlying he NPV rule. As a resul, he NPV rule provides lile explanaory power for he observed corporae invesmen behaviour in pracice. Given he imporance of corporae invesmen decision in maximising shareholders wealh, a number of more sophisicaed invesmen heories, such as Tobin s Q heory, acceleraor heory, financial consrains heory and real opions heory, have been developed, aiming o fill he heory-pracice gap Tobin s Q model Tobin s Q is developed by Tobin (1969) as a raio of he marke value of reproducible real capial asses o he curren replacemen cos of hose asses. Companies wih Tobin s Q raios greaer han one should have an incenive o inves, since he marke value of he asse being reproduced is greaer han he curren replacemen cos of he asse. Conversely, companies wih Tobin s Q raios less han one should curail invesmen. Accordingly, he sandard Tobin s Q heory saes ha he marginal Q, which can be measured as he raio of he capialised value o he replacemen cos of he marginal invesmen, summarises he effecs of all he facors relevan o a company s invesmen decisions, and hus he company s corporae invesmen should be an increasing funcion of is marginal Q (see, for example, Blanchard and Fischer, 1989). In oher words, Tobin s Q heory implies ha all he informaion relevan o he expeced fuure profiabiliy affec corporae invesmen decisions hrough heir effecs on he marginal Q. High marginal Q values (if he marginal Q exceeds one) encourage companies o underake new invesmens or expand curren operaions, while 19

36 Chaper 2: Lieraure Review low marginal Q values (if he marginal Q falls below one) sugges companies rejec invesmen opporuniies and reduce exising invesmens. The opimal invesmen level is reached when he marke value of he incremenal uni of capial is equal o is replacemen cos, i.e. when he marginal Q is equal o one. Alhough some empirical sudies find ha Tobin s Q and invesmen raes are posiively correlaed (see, for example, Ascioglu e al., 2008; Aggarwal and Zong, 2006; and Erickson and Whied, 2000), he empirical performance of Tobin s Q model of invesmen is far from saisfacory. This is largely aribuable o a number of reasons. Firs, in he absence of a secondary marke where he ownership of an invesmen can be raded, he capialised value of invesmen is very difficul o observe, and hus he marginal Q is in fac unobservable. As a resul, average Q, which is defined as he raio of marke value o he replacemen value of capial sock, is ypically used as a proxy for marginal Q in empirical sudies (Erickson and Whied, 2000). As noed in Lensink and Murinde (2006), he measure of marginal Q is problemaic, and differen proxies for he marginal Q have been used in empirical lieraure. Thus, he disappoining empirical performance of Tobin s Q heory is primarily aribuable o severe measuremen errors. Second, i is argued ha Tobin s Q does no carry all he informaion relevan o invesmen decisions, and some facors, such as capial marke consrains, adjusmen coss and uncerainy, may affec invesmen apar from Tobin s Q. For example, Ferderer (1993) finds ha uncerainy has a larger impac on invesmen han does average Q, and ha exending a sandard Tobin s Q model of invesmen 20

37 Chaper 2: Lieraure Review by including uncerainy measures improves he performance of he model significanly. In addiion, Dixi and Pindyck (1994) poin ou ha, in order o deermine he value of Tobin s Q, he capialised value of an invesmen has o be calculaed as he expeced presen value of he sream of profi i would yield, and herefore he underlying principle of Tobin s Q heory is sill he basic NPV model Acceleraor model The acceleraor principle saes ha he sock of capial goods is supposed o be proporional o he level of producion, and companies engage in capial invesmen in an aemp o close he gap beween he desired sock of capial good and exising sock of capial goods lef over from he pas (see, for example, Lucas, 1967; and Chenery, 1952). According o his view, if he capial o oupu raio is consan, a change in a company s oupu or sales requires a corresponding amoun of invesmen o adjus is capial sock owards he desired level. The economic logic underlying he acceleraor effec is ha increased sales indicae ha a company is likely o make more profis and greaer use of exising capaciy in he fuure, which would encourage companies o spend more funds on capial sock. The increased capial expendiure may lead o furher growh of sales and profis, causing a muliplier effec. On he conrary, falling sales hurs a company s profi and use of capaciy, which in urn discourages capial invesmen and worsens he company s prospecs via he muliplier effec. The relevance of he acceleraor effec has been verified by a large number of empirical sudies. For example, Lensink and Serken (2000) find ha corporae invesmen is 21

38 Chaper 2: Lieraure Review highly sensiive o increase in sales for boh small and large companies, which is consisen wih he cenral predicion of he acceleraor heory. Bo and Lensink (2005) invesigae he invesmen-uncerainy relaionship for a panel of Duch non-financial companies based on a sandard acceleraor model. They find ha, as expeced, he esimaed coefficien for he change in sales is highly significan wih a posiive sign. Furhermore, Lensink (2002) finds ha, a an aggregae level, he acceleraor ype of effec, which is measured by he growh rae of real gross domesic produc (GDP), also has imporan power in explaining he variaion in he invesmen o GDP raio for a group of 17 developed counries. The dynamic relaionship beween capial sock and oupu has also been uilised o derive an error correcion model (ECM), which is able o provide a flexible disincion beween shor-run and long-run influences of changes in a company s oupu on is invesmen behaviour (see, for example, Bloom e al., 2007; and Bond e al., 2003). The error correcion behaviour is aken ino accoun because he presence of adjusmen coss makes i impossible for a company o adjus is capial sock o he desired level, which is considered as a funcion of oupu, immediaely (see Guariglia, 2008). The error correcion specificaion is widely used in empirical works on corporae invesmen. By examining he dynamic relaionship beween capial sock and real sales of a panel of manufacuring companies, Bond e al. (2003) find ha capial sock and real sales series are indeed coinegraed, which shows empirical relevance of he long-run proporionaliy imposed in he error correcion model. More imporanly, hey find ha he error correcion erms are correcly signed and saisically 22