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

Transcription

1 Legal Protection, Equity Dependence and Corporate Investment: Evidence from around the World * Yuanto Kusnadi Hong Kong University of Science and Technology K.C. John Wei Hong Kong University of Science and Technology July 2006 Abstract In this paper, we investigate the effect of legal protection of investors and the equity-financing channel on the relationship between corporate investment and stock prices in an international setting. We find that firms in countries with stronger legal protection of investors have corporate investment that is more sensitive to their stock prices. In addition, equity-dependent firms display a higher sensitivity of corporate investment to stock prices than do nonequity-dependent firms, which is consistent with the equity-financing channel argument. Finally, the positive relation between legal protection and the investment-stock price sensitivity is more profound for equity-dependent firms than for nonequity-dependent firms. Overall, our evidence complements the earlier finding by Baker et al. (2003) and suggests that both legal protection of investors and the equity-financing channel influence managers corporate investment decisions with respect to changes in stock prices. * addresses: yuanto@ust.hk (Yuanto Kusnadi), johnwei@ust.hk (K.C. John Wei). Phone: (John Wei); Fax: We thank seminar participants at the 2006 FMA/Asian Finance Association Conference (Auckland), the 2006 Chinese International Conference in Finance (Xi an), Hong Kong University of Science and Technology, and Nanyang Technological University for helpful comments and discussions. The authors also thank Dr. Virginia Unkefer for editorial assistance. We acknowledge financial support from an RGC Competitive Earmarked Research Grant of the Hong Kong Special Administration Region, China (Project no. HKUST6448/05H). All remaining errors are ours.

2 1. Introduction Existing literature has documented ample evidence of a positive relationship between corporate investment and stock prices. In an informationally efficient market, the traditional explanation for this observed positive association is that stock prices (measured by Tobin s Q) reflect the market s information about a firm s investment opportunities or the marginal rate of return on capital. This interpretation suggests that corporate investment and Tobin s Q are positively correlated. Many recent international studies have acknowledged the impact of legal protection of investors on the various aspects of financial markets. 1 In particular, these studies show that stock markets in countries with stronger legal protection of investors and more effective securities regulations have larger and deeper capital markets (La Porta et al. (1997, 1998)), a higher number of listed firms (La Porta et al. (1997)), greater use of external financing (La Porta et al. (1998)), higher firm valuation (La Porta et al. (2002)), and a lower cost of capital (Chen et al. (2005) and Hail and Leuz (2006)). 2 In addition, stronger legal protection of investors rights further promotes more efficient allocation of capital by preventing managers from overinvesting in declining sectors (Wurgler (2000)). These studies suggest that stock prices should reflect investment opportunities or the marginal product of capital better in countries with stronger legal protection of investors. More specifically, the positive relation between corporate investment and the stock market should be more pronounced in countries with strong legal protection of minority shareholders than in countries with weak legal protection of these shareholders. However, few studies examine if 1 See Beck and Levine (2005) for an excellent review of the literature on law and finance. 2 In a related study, Daouk et al. (2006) further emphasize the role of securities regulations in their design of a capital market governance (CMG) index. They show that countries with a higher CMG index tend to have lower cost of equity as well as higher market liquidity and greater market efficiency. 1

3 cross-country differences in the legal protection of investors are possible determinants of firmlevel corporate investment. 3 Recent papers in behavioral finance have suggested that stock markets may not be efficient and these studies have offered an alternative explanation for the positive relationship between corporate investment and stock prices through the equity-financing channel. More specifically, the existence of a non-fundamental component in stock prices causes the effective cost of external equity to deviate from the cost of other forms of capital. In turn, this divergence affects a firm s equity financing and, consequently, its capital investment decisions. Stein (1996) and Baker et al. (2003) argue that if the equity-financing channel is the cause of the positive relationship between corporate investment and the stock market, corporate investment should be more sensitive to changes in the non-fundamental component of stock prices in equity-dependent firms (i.e., those firms that have capital constraints and have to raise external equity to finance investment projects) than in nonequity-dependent firms. 4 The reason is that equity-dependent firms have incentives to raise equity for their corporate investment when their stock prices are overvalued (above their fundamental values), but they would forgo their investment rather than issue new equity when their stock prices are undervalued. In contrast, the scenarios are different in nonequity-dependent firms, because stock price mispricing is unlikely to affect their corporate investment decisions. A recent paper by Almeida and Wolfenzon (2005) further show that equity dependence has a positive impact on the efficiency of capital allocation. Even after controlling for the effect of legal protection, the presence of financial constraints will drive firms that are more reliant on 3 Kelley and Woidtke (2005) examine the role of investor protection on real investment. But their focus is on the foreign investments made by multinational U.S. firms. Hartzell et al. (2006) examine the effect of firm-level corporate governance mechanisms on corporate investment in REIT firms. 4 Gilchrist et al. (2005) and Polk and Sapienza (2005) examine the effect of stock market mispricing on corporate investment. 2

4 external equity to switch from an average to a more productive project. Both Baker et al. (2003) and Almeida and Wolfenzon (2005) empirically examine U.S. firms and find evidences that are consistent with their predictions and highlight the role of the equity-financing channel. However, very little is known regarding the relationship between corporate investment, equity dependence and stock markets outside the U.S., especially in those emerging economies where the capital markets are less developed. The primary objective of this paper is to examine the effect of legal protection of investors and the equity-financing channel on the relationship between corporate investment and stock prices across the world. We hypothesize that firms in countries with stronger legal protection of investors should have corporate investment that is more sensitive to their stock prices. In addition, if the equity-financing argument is valid, we predict that the effect of stock prices on investment should increase as the degree of equity dependence increases. Our last hypothesis considers the interaction between legal protection and equity dependence on the relationship between corporate investment and stock prices. Specifically, we predict that the effect of legal protection on the sensitivity of corporate investment to stock prices should be more pronounced in equity-dependent firms. To the best of our knowledge, there has been no previous empirical study that examines these issues simultaneously. We employ three indices from La Porta et al. (1998, 2006) and the modified KZ index from Kaplan and Zingales (1997) as our measures of legal protection and equity dependence, respectively. Our first main result indicates that legal protection is positively related to the sensitivity of corporate investment to stock prices. In other words, firms in countries with stronger legal protection display a higher sensitivity of corporate investment to stock prices. Next, we use the tests suggested by Baker et al. (2003) and confirm the role of the equity-financing 3

5 channel in our international sample in that the positive effect of stock prices on investment increases monotonically as the degree of equity dependence increases. Finally, our last test on the interaction between legal protection and equity dependence reveals that the positive association between legal protection and the effect of stock prices on corporate investment is more pronounced in equity-dependent firms. In summary, our empirical findings are consistent with our three main hypotheses and are robust to alternative specifications. We interpret our results to be consistent with the conclusions reached by Baker et al. (2003) on a sample of U.S. firms and by the traditional explanation of the positive relation between corporate investment and stock prices. Both legal protection and the equity-financing channel influence managers corporate investment decisions with respect to changes in stock prices. Stronger legal protection of investors in the forms of anti-directors rights and enforcement of securities laws promotes efficient allocation of capital and serves to prevent managers from undertaking value-destroying investments. This implies that stock markets in countries with strong legal protection reflect investment opportunities better, suggesting the higher sensitivity of corporate investment to stock prices. In contrast, the equity-financing channel argument suggests that the corporate investment of equity-dependent firms is more responsive to non-fundamental variations in stock prices. Overall, these two factors combine to help equity-dependent firms achieve efficient investment levels in countries with strong legal protection. The remainder of this paper is organized as follows. Section 2 reviews the literature and develops our hypotheses. Section 3 describes the source of our data. Section 4 presents the empirical tests of our hypotheses and discusses the results. Section 5 concludes the paper. 4

6 2. Literature Review and Hypothesis Development 2.1 Corporate investment and the stock market Most of the theoretical work on the relationship between the stock market and corporate investment predicts that corporate investment should be positively associated with stock prices. The traditional explanation of the relationship is the Q-theory of investment (Tobin (1969)). In an efficient market, stock prices (as measured by Tobin s Q) represent investment opportunities, and a firm will continue to pursue investment projects until it reaches the level where the market value of its assets is equal to the replacement cost of its physical capital (i.e., Q = 1). An alternative view is based on the equity-financing channel. For example, Keynes (1936) points out that stock market mispricing has an effect on the cost of equity, while Bernanke and Gertler (1995) and others argue that stock market mispricing can also affect the cost of debt through its effect on perceived collateral values. Stein (1996), Baker et al. (2003), and others suggest that since mispricing causes the effective cost of external equity to deviate from the cost of other forms of capital, stock prices can influence equity financing patterns, and, in turn, managers corporate investment decisions. The empirical evidence is, however, less settled. While Morck et al. (1990) and Blanchard et al. (1993) find little evidence that the stock market affects corporate investment, Chirinko and Schaller (2001), Baker et al. (2003), and Chen et al. (2006) find that the stock market has an important effect on corporate investment. In particular, Chen et al. (2006) use price synchronicity and PIN (the probability of informed trading) as proxies for the degree of price informativeness and find that these measures increase the sensitivity of investment to stock prices. 5

7 2.2 Legal protection, corporate investment and the stock market Legal protection includes not only the rights prescribed regulations and laws, but also the effectiveness of enforcement. In a series of papers, La Porta et al. (1997, 1998, and 2002) examine the various aspects of legal protection of outside investors across 49 countries and document that these institutional characteristics matter to capital market development, corporate governance, and firm value. In particular, they find that legal protection is the strongest in English common law countries and the weakest in French civil law countries, with German and Scandinavian civil law countries falling in between. Moreover, countries with stronger legal protection of minority shareholders have better corporate governance, more developed capital and debt markets, larger stock market capitalizations, larger numbers of listed securities per capita, and a higher rate of IPOs than do countries with weak legal protection of investors. They further show that firms in countries with stronger shareholder protection have higher firm value than do firms in countries with weaker shareholder protection. In a more recent paper, La Porta et al. (2006) examine how securities laws affect capital market development in the same 49 countries used in their earlier studies. Their findings strongly suggest that laws do matter, especially in countries that facilitate private enforcement through disclosure requirements and liability rules. Using the dataset from La Porta et al. (2006), Hail and Leuz (2006) document that the effectiveness of legal institutions and securities regulations is significantly negatively related to the country-level cost of equity capital. A related study by Chen et al. (2005) further reports that firms in emerging markets with more effective corporate governance have a lower implied cost of equity, especially in countries with weaker legal protection of investors. Wurgler (2000) shows that financial markets play an important role in 6

8 the efficient allocation of capital. More importantly, legal protection of investor rights is one mechanism through which efficient allocation of capital can be achieved. Since legal protection of investors affects the development of financial markets, the cost of capital, and the efficiency of investment, we expect that legal protection of investors should have a positive effect on the sensitivity of corporate investment to stock prices, especially in equitydependent firms. Studies on corporate governance have suggested that entrenched managers have incentives to engage in empire building and other destructive activities, which leads to inefficient corporate investment decisions. Therefore, corporate investments may not be sensitive to investment opportunities (i.e., stock prices) for firms in countries with weak legal protection of investors. Strong legal protection helps alleviate the agency conflicts between corporate managers and minority shareholders by directing managers into investing in growing sectors and preventing them from overinvesting in declining sectors. In addition, firms in countries with strong legal protection of investors face less constraint in raising external funds to finance their investment projects. 5 Taken together, these studies suggest that stock prices should reflect investment opportunities better and managers should allocate their capital more efficiently in countries with strong legal protection of investors than in countries with weak legal protection of investors. This implies that the corporate investment of these firms should be more responsive to their stock prices. The above arguments lead to the following hypothesis: Hypothesis 1: Firms in countries with strong legal protection of investors have corporate investment that is more sensitive to their stock prices. 5 A related paper by Love (2003) documents financial development helps to overcome the financing constraints faced in corporate investment decisions. Sheilfer and Wolfenzon (2002) further discuss how an increase in legal protection will mitigate the problem of limited pledgibility of cash flows. 7

9 2.3 Equity dependence, corporate investment and the stock market Baker et al. (2003) extend the model by Stein (1996) and derive implications on the role of the equity-financing channel on corporate investment. They argue that stock market irrationality is unlikely to affect the investment decisions of nonequity-dependent firms (those with sufficient liquidity and no debt). In contrast, equity-dependent firms will not want to go to the external market to issue equity when their stocks are undervalued, despite their need to raise funds for investment. The opposite happens in the cases of overvaluation in that equity-dependent firms are willing to issue equity to finance their investment under such circumstances. Therefore, equity-dependent firms have their capital investment that is more sensitive to variations in the non-fundamental component of stock prices than do nonequity-dependent firms. Baker et al. (2003) use a modified KZ index first constructed by Kaplan and Zingales (1997) as a measure of equity dependence to examine the effect of equity dependence on the relationship between corporate investment and stock prices. 6 More specifically, their modified KZ index is negatively related to cash flow, cash dividends, and cash balances; and it is positively associated with leverage. Baker et al. (2003) document that their empirical findings on firms in the U.S. are consistent with their theoretical predictions. Our hypothesis on the effect of equity dependence follows that of Baker et al. (2003). Specifically, we expect that the sensitivity of corporate investment to stock prices is stronger for equity-dependent firms than for nonequity-dependent firms. 6 The original KZ index also includes Tobin s Q. However, Baker et al. (2003) report similar results when they use the original KZ index. Baker et al. (2003) define a firm as equity-dependent if the firm s stock price is undervalued and its available wealth is low enough that it has to issue undervalued equity to achieve the first-best level of investment. The original KZ index has been widely used to measure the degree of financial constraints or equity dependence. For example, Lamont et al. (2001) use the KZ index to examine the impact of financial constraints on stock returns. 8

10 Hypothesis 2: Equity-dependent firms have corporate investment that is more sensitive to their stock prices that do non-equity-dependent firms. 2.3 Legal protection, equity dependence, corporate investment and the stock market Baker et al. (2003) further argue that the presence of agency problems increases the incentives of managers of nonequity-dependent firms to smooth investment. Moreover, Almeida and Wolfenzon (2005) develop a model and show that both investor protection and equity dependence affect the efficiency of capital allocation. In the absence of financial constraints and adequate level of investor protection, managers tend to keep average projects. Therefore, the corporate investment of these nonequity-dependent firms in countries with low investor protection may not be responsive to changes in their stock prices. When the level of investor protection increases, outside investors will demand managers to terminate projects with low productivity and switch to those with high productivity in order to improve their future returns. The presence of financial constraints will further require managers to commit in the termination of average projects in order to raise external equity capital. In that way, it will free up useful resources which will be channeled to more productive purposes. Therefore, controlling for the effect of legal protection, an increase firm s equity dependence level should lead to a positive effect on the efficiency of capital allocation. We have earlier hypothesized that the positive association between corporate investment and stock prices should increase as the degree of equity dependence increases. By considering the effects of both legal protection and equity-financing channel, we posit that the positive relationship between legal protection and the effect of stock prices on corporate investment should be more pronounced for equity-dependent firms than for nonequity-dependent firms. 9

11 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. 3. Data and Sample Statistics We collect two sets of data. The first dataset involves measures of legal protection of investors at the country level. Following previous literature, we measure legal protection of investors based on the following three indices from La Porta et al. (1998, 2006): (1) antidirectors rights; (2) public enforcement; and (3) private enforcement. The second dataset consists of firm-level financial data. Our firm-level data come from Worldscope and Datastream, which are provided by Thomson Financial. After excluding the U.S., we manage to retrieve firm-level data for 43 out of the 49 countries covered by La Porta et al. (1998, 2006). For each firm, we collect financial variables that include capital expenditures, cash flow, cash balances, cash dividends, total debt, total assets, and book value of equity from Worldscope and market value of equity from Datastream. From the initial sample, we exclude firms with missing firm-year observations, firms operating in the financial industry (firms with SIC codes between 6000 and 6999), and firms with book values of total assets of less than US$10 million. 7 Overall, our filtering process yields an unbalanced panel data of 110,882 firmyear observations for 17,009 firms from 43 countries. The sample period is from 1985 to Table 1 partitions the countries into 4 groups: Asia Pacific (14 countries), Western Europe (18 countries), Canada and South America (8 countries), and Africa (3 countries). The second column of Table 1 reports the total firm-year observations for each country in the final sample. 7 We use the exchange rates from Datastream to convert the book values of total assets from local currencies to U.S. dollars. 10

12 Japan and the United Kingdom dominate the sample, each with more than 17,000 firm-year observations. 8 [Insert Table 1 here] 3.1 Country-level legal protection variables As mentioned earlier, the legal protection variables are taken directly from the work of La Porta et al. (1998, 2006). The first variable, the anti-directors rights index, has been widely used in many studies as a proxy for the effectiveness of corporate governance. 9 It is constructed by adding one to each of the six rights that are intended to measure the degree of minority shareholders involvement in corporate decisions. It ranges from 0 to 6 with a higher value indicating a stronger degree of legal protection. The second and third measures are obtained from La Porta et al. (2006). 10 The private enforcement index is constructed by taking an arithmetic average of the disclosure requirements and liability standard indices. It ranges from 0 to 1. Similarly, a higher value on this index suggests more effective private enforcement of securities laws than does a lower value. The disclosure requirements index captures regulations on the information that must be disclosed in an IPO transaction. The liability standards index measures the procedural difficulty in recovering losses from directors, distributors, and accountants. In sum, the private enforcement index measures the costs that investors need to incur to recover losses from corporate insiders, distributors of securities, and accountants. 8 We exclude Japan and the United Kingdom in one of our robustness checks to ensure that our main results are not driven by observations from these two countries. 9 Dittmar et al. (2003) examine the cash holdings decisions for 45 countries and find that firms in countries with higher anti-directors rights (which indicate more effective corporate governance) hold less cash. 10 See La Porta et al. (2006) for a more complete explanation on the various components that make up the private and public enforcement indices. 11

13 The public enforcement index is constructed by taking an arithmetic average of the supervisor characteristics, rule-making power, investigative powers, orders, and criminal indices It ranges from 0 to 1, with a higher value signifying more effective enforcement of securities laws by the regulators. The supervisor characteristics index captures three aspects of the Supervisor (the regulatory agency or official in charge of the securities market): its independence, criteria for dismissal, and focus on the securities markets. The rule-making power index measures the power of the Supervisor in regulating equity-issuances and/or listing rules on the exchanges. The investigative power index measures the power of the Supervisor in gathering the necessary documents and the ability to subpoena witness testimony in the case of litigation. The orders index measures the power of the Supervisor in imposing sanctions on issuers, distributors, and accountants for non-criminal violations of securities laws. The criminal index measures the power to enforce sanctions for criminal violations of securities laws. In sum, the public enforcement index measures the power of the capital market supervisory agency in regulating and enforcing the securities laws. In addition to the three legal protection measures, we also use the legal origin variable because La Porta et al. (1998) have shown that the common-law countries offer stronger legal protection to investors than do countries with other legal traditions. 11 For convenience, we use a dummy variable that equals one for English common-law countries and zero for French or German or Scandinavian civil-law countries in regression specifications that include the legal origin as an independent variable. From the third column of Table 1, we observe that there is wide variation in the legal origin of the countries in our sample. The majority of countries in the Asia Pacific (9 out of 14) and 11 Ball et al. (2000) provide evidence that the demand for timely and conservative accounting numbers is higher in common-law countries than in code-law countries. 12

14 Africa (2 out of 3) adopt the English common-law system. In contrast, the French civil-law system is followed in South America and most of the countries in Western Europe (8 out of 18). The third column of Table 1 shows that Asia Pacific countries exhibit the highest anti-directors rights (3.57) and Western European countries exhibit the lowest (2.56). Only Belgium has an anti-directors rights index of 0 and six countries (Hong Kong, India, Pakistan, Canada, Chile, South Africa) have an anti-directors rights scores of 5. The fourth and fifth columns of Table 1 provide the statistics on the private and public enforcement indices. The private enforcement score ranges from 0.18 (Austria) to 0.96 (Canada) and the public enforcement score ranges from 0 (Japan) to 0.90 (Australia). Similar to the pattern that we observed earlier for the anti-directors rights index, the Asia Pacific countries exhibit the highest average scores for both indices (0.69 and 0.60), while Canada and South America and Africa exhibit the lowest average scores for the private enforcement index (0.42) and the public enforcement index (0.32), respectively. Similar to the finding by La Porta et al. (1998), we also document that there exists a positive correlation between the legal origin and anti-directors rights, with common-law countries reporting higher anti-directors rights scores and civil-law countries reporting lower anti-directors rights scores. This is consistent with the notion that common-law countries in general provide stronger legal protections to investors. 3.2 Firm-level financial variables For each firm, i, our measure of corporate investment (CAPX it ) is calculated as capital expenditures in year t divided by total assets at the end of year t-1. Cash flow (CF it ) is calculated as income before extraordinary items plus depreciation and amortization in year t divided by 13

15 total assets at the end of year t-1. Finally, our measure of stock price, Tobin s Q (Q it ), is calculated as the market value of equity (stock price multiplied by the number of shares outstanding) plus total assets minus the book value of equity divided by total assets (at the end of year t). We winsorize all financial variables at the 1 st and 99 th percentile levels to minimize the problems of outliers. Kaplan and Zingales (1997) construct the original five-variable KZ index on a sample of 49 low-dividend manufacturing firms in the U.S. as a measure of financial constraints. They estimate the following regression equation to construct the KZ index for each firm-year observation: KZ = 1.002CF DIV 1.315CASH LEV Q, (1) it it it it it it where KZ it is the KZ score for firm i in year t. CASH it is cash balances and is calculated as cash balances at the end of year t divided by total assets at the end of year t-1. LEV it is leverage and is calculated as the sum of long-term debt and debt in current liabilities divided by the sum of longterm debt, debt in current liabilities, and book value of equity (all measured at the end of year t). DIV it is dividends and is calculated as cash dividends paid in year t divided by total assets at the end of year t-1. CF it and Q it are cash flow and Tobin s Q in year t as defined earlier. Baker et al. (2003) argue that Tobin s Q captures information about stock mispricing and is often used as a proxy for investment opportunities. To avoid this dual role for Q, we follow their approach and use a modified four-variable version of the KZ index that omits Q in the baseline specification. We use this modified KZ index as our measure for equity dependence. 12 Firms with higher KZ scores are considered to be more equity-dependent or more reliant on external equity financing for their investment projects. 12 Note that we first winsorize the components of the KZ index at the 1 st and 99 th percentile before estimating equation (2). 14

16 More specifically, we estimate equation (2) below to construct the four-variable KZ index for each firm-year observation: 13 KZ = 1.002CF DIV 1.315CASH LEV. (2) it it it it it Panel A of Table 2 presents the summary statistics of the financial variables. The mean (median) corporate investment (CAPX t ) across the 43 sample countries is 7.5 (4.7) percent. The value for our international sample is lower compared with the mean (median) of 8.2 (6.0) percent reported by Baker et al. (2003) on a sample of U.S. firms. The mean (median) cash flow (CF t ) is 7.7 (7.8) percent; the mean (median) Tobin s Q (Q t ) is 1.4 (1.1), and the mean (median) KZ index is 0.2 (0.3). For the subsamples, we observe that the Asia Pacific countries have the largest mean KZ score and the smallest mean corporate investment, Tobin s Q, and cash flow. Canada and South American countries have the largest mean corporate investment. Western European countries have the largest mean Tobin s Q, and African countries have the largest mean cash flow and smallest mean KZ score. [Insert Table 2 here] Additionally, we compute the Pearson correlations among the financial variables and the legal protection measures. The results are presented in Panel B of Table We observe that the KZ Index is mostly negatively correlated to the other financial variables as well as the legal protection variables. The correlations between the other financial variables and the legal protection variables are generally negative (6 out of 9), with magnitudes ranging from to The correlations between corporate investment and Tobin s Q and cash flow are both positive, which is consistent with the evidence reported in the literature. We verify the univariate 13 We use the modified KZ index in our subsequent empirical tests. However, in our unreported tests, we obtain similar results when we use the original five-variable KZ index. 14 The country-median values for the financial variables are used to compute the correlation coefficients. 15

17 results by estimating the baseline investment regression in the next section. Finally, the correlations among the three legal protection variables are all in the expected direction (positive) with magnitudes ranging from 0.37 to Empirical Results and Discussions In this section, we formally investigate the role of legal protection of investors and equity dependence in the relationship between a firm s stock price and its corporate investment. Specifically, we empirically examine (i) if legal protection of investors affects corporate investment, (ii) if the empirical evidence found in U.S. firms on the relationship between the equity-financing channel and corporate investment (Baker et al. 2003) can be extended to international markets, and (iii) if legal protection of investors has an effect on corporate investment via the equity-financing channel. Our research design closely follows that of Baker et al. (2003). 4.1 Specification of the investment equation: the role of legal protection of investors Following Fazzari et al. (1988) and Baker et al. (2003), we estimate the following baseline investment equation for our international sample: CAPX = a + a + bq 1 + fcf + u, (3) it i t it it it where CAPX it is the corporate investment of firm i in year t, Q it-1 is its Tobin s Q in year t-1, and CF it is its cash flow in year t. These variables are defined earlier. Regression coefficients b and f measure the sensitivity of corporate investment to stock prices and cash flows, respectively. We adopt the same approach as Baker et al. (2003) in estimating the fixed effects model for our panel data. We include firm (a i ) and year (a t ) dummies to control for the individual firm and 16

18 year effects. The u it is an error term that is assumed to be independent of the explanatory variables. In order to mitigate the problems of serial auto-correlation and heteroskedasticity, we estimate White s heteroskedasticity corrected robust standard errors (clustered by firm). Model (1) in Panel A of Table 3 presents the coefficients for the baseline investment equation (3) with CAPX it as the dependent variable and Q it-1 and CF it as explanatory variables. We find that both regression coefficients (b and f) are positive and statistically significant at the one percent level. The finding for our international sample corroborates the prevailing general results that corporate investment is positively correlated to both stock prices and cash flow. [Insert Table 3 here] Our next task is to test the effect of legal protection of investors on the sensitivity of corporate investment to stock prices. In order to test Hypothesis 1, we modify equation (3) to include our measures of legal protection and estimate the modified investment equation below: CAPX + it = ai + at + bqit 1 + c( Qit 1 LPi ) + fcfit uit, (4) where LP i is one of the legal protection of investors measures for firm i. Note that firms from the same country will have the same value of LP. The other variables are as defined previously. The coefficient of interest in this case is the interaction coefficient, c. Hypothesis 1 predicts that c is positive. In other words, we conjecture that legal protection of investors increases the sensitivity of corporate investment to stock prices. We estimate equation (4) by including the interaction of each of the three measures of legal protection (anti-directors rights, private enforcement, and public enforcement) with Tobin s Q as an additional independent variable. The results of the fixed-effects regressions are reported in 15, 16 Models (2) to (4) of Table We have also estimated fixed-effects regressions that include legal protection as another independent variable and obtain similar results. The interaction term coefficients remain positively significant at the one percent level. More 17

19 Although the b coefficients in Models (2) to (4) are smaller in magnitude when compared to the b coefficient in Model (1), they continue to be positive and statistically significant at least at the five percent level. The magnitudes of the f coefficients are also stable across Models (1) to (4). More importantly, we find that the interaction term coefficient (c) is positive and significant in all three models (with t-statistics of 3.41, 3.14, and 6.96 respectively), which supports Hypothesis The economic significance of the result is quite substantial. A one standard deviation increase in the anti-directors rights index increases the sensitivity of corporate investment to stock prices by about 22 percent. Similarly, a one standard deviation increase in the private (public) enforcement index leads to a 30 (55) percent increases in the sensitivity of corporate investment to stock prices. 18 In addition, we use the median value of the legal protection variables to split our sample into countries with low and high legal protection. 19 We repeat the estimation of equation (3) on both subsamples and present the results in Panel B of Table 3. For the sake of brevity, we only report the coefficients of Q. We find that the coefficients of Q are higher in countries with high values interestingly, we find that all our measures of legal protection are negatively associated with corporate investment, suggesting that firms in countries with stronger legal protection engage in less corporate investments. 16 In another unreported regressions, we include the legal protection measures and its interaction with cash flow as an additional regressor. While the interaction term with Tobin s Q displays a positive association with corporate investment, the interaction term with cash flow is negative and significant at the one percent level for all measures of legal protection. Our interpretation is that strong legal protection helps overcome the information asymmetry between managers and minority shareholders. As a result, firms in countries with strong legal protection show a smaller sensitivity of corporate investment to cash flow than do firms in countries with weak legal protection. In these strong legal protection countries, corporate investment is not so much affected by liquidity constraints, suggesting that legal protection can mitigate the underinvestment problem. 17 We obtain similar results when we replace the private enforcement index with its components (disclosure requirements and liability standard). 18 For anti-directors rights, the change in the sensitivity of corporate investment to stock price is [(0.0015*1.31)/0.0090]*100% = 22 percent. For private enforcement, the value is [(0.19*0.011)/0.007]*100% = 30 percent. For public enforcement, the value is [(0.22*0.015)/0.006]*100% = 55 percent. 19 The median values for the anti-director rights, private enforcement, and public enforcement indices are 3, 0.55, and 0.52 respectively. 18

20 of the three measures of legal protection. In particular, the t-statistics obtained from a test of difference in the coefficients between low and high legal protection countries are highly significant at the one percent level. Since legal origin is correlated with the legal protection variables, we estimate an alternative specification of equation (4) below: CAPX + it = ai + at + bqit 1 + c( Qit 1 LOi ) + fcfit uit, (5) where LO i is the legal origin dummy variable for firm i. It equals zero for civil-law countries and one for common-law countries. Similar to LP, firms from the same country also have the same LO value. The other variables are as defined previously. We again hypothesize that c is positive, which suggests that firms in countries with common-law systems have corporate investment that is more sensitive to stock prices than do firms in countries with civil-law systems. We estimate equation (5) using a fixed-effects model and present the coefficients in Model (1) of Table 4. The result confirms our prediction that the coefficient c is significant with the expected sign (positive). In fact, firms in English common-law countries display a substantially higher sensitivity of corporate investment to stock prices by about 64 percent than do firms in civil-law countries. 20 [Insert Table 4 here] By combining the legal origin and the legal protection measures, we estimate equation (6) below: CAPX + it = ai + at + bqit 1 + c( Qit 1 LOi LPi ) + fcfit uit, (6) where the variables are as defined previously. Likewise, we expect c to be positive, which suggests that firms in countries with common-law systems and strong legal protections of 20 The increase in the sensitivity of corporate investment to stock prices is (0.007/0.011)*100% = 64 percent. 19

21 shareholders have corporate investment that is more sensitive to stock prices than do firms in countries with civil-law systems and weak legal protections of shareholders. We include the interaction of each of the three measures of legal protection with the legal origin dummy as well as Tobin s Q as an additional independent variable. The estimation results of equation (6) using the fixed-effects model are presented in Models (2) to (4) of Table 4. Indeed, we find that the coefficient c is positive and significant at the one percent level in all three models as expected. Subsequently, we perform a series of additional checks to examine whether our results are robust to alternative specifications. In the first robustness test, we use the investor protection index (which is the principal component of the disclosure requirements, liability standard, and anti-directors rights indices) as our proxy for legal protection and re-estimate equation (4) using both firm fixed-effect and country random-effect specifications to control for firm-specific and cross-country variations. We report the coefficients in Model (1) and (2) of Table 5. The standard errors reported are White s heteroskedasticity corrected robust standard errors (clustered by country). We show that our main result continues to hold in that the interaction coefficient c remains positive and highly significant (t-statistic = 5.02) in Model (1). Moreover, despite the reduction in the adjusted R 2 of the model from 0.45 in Model (1) to 0.15 in Model (2), we still obtain a positive and significant coefficient for c (t-statistic = 2.58) in the specification that controls for country random-effect. Next, we exclude Japan and the United Kingdom from our sample to check if our results persist after dropping observations from these two countries that dominate our sample. We still use the investor protection index and re-estimate equation (4) using the fixed-effects model. We report the results in Model (3) of Table 5. We show that the coefficient c remains positive and 20

22 significant (t-statistic = 3.42), which suggests that our main finding is not driven by observations from Japan and the United Kingdom. In addition, we employ three other measures that previous studies have found to be alternative measures of corporate governance. The first measure is the corporate board index from the Institute for Management Development. The index is available for 35 out of the 43 countries in our sample, with South Korea having the lowest score (4.45) and Denmark and Finland having the highest score (7.55). Since a higher score on the index indicates more effective corporate governance from the board of directors, our prediction is similar to the earlier prediction on the legal protection variables. The second measure is the earnings management index constructed by Leuz et al. (2003). 21 This index is available for only 31 countries in our sample, ranging from the lowest score of 4.8 (Australia) to the highest score of 28.3 (Austria and Greece). Unlike the other measures of legal protection, a higher score on this index implies that firms in the particular country are more prone to earnings management, indicating that legal protection is likely to be low for that country. This time, we predict that the coefficient c should be negative. The third measure is the capital market governance (CMG) index constructed by Daouk et al. (2006). 22 This index is intended to measure the extent and enforcement of capital market regulations. It is available for only 32 countries in our sample, ranging from the lowest score of 0.98 (India) to the highest score of 8.54 (Brazil). Since a higher CMG index indicates a higher quality of market governance, our prediction is again similar to the earlier prediction on the legal protection variables. 21 See Leuz et al. (2003) for the details on the construction of the earnings management index. 22 See Daouk et al. (2006) for the details on the construction of the capital market governance index. 21

23 We repeat the estimation of equation (4) by including interaction terms involving the three alternative indices and present the results of the fixed-effects regressions in Models (4) to (6) of Table 5. We find that the coefficient c is positive and significant (t-statistics = 5.37 and 1.89) in Model (3) and (5), and negative and significant (t-statistic = -5.54) in Model (4), respectively. The results are consistent with our predictions. Therefore, firms in countries with higher scores on the corporate board and capital market governance indices and lower scores on the earnings management index display a larger sensitivity of corporate investment to stock prices. This indicates that our results are robust regardless of the measures of legal protection used in the specification. Finally, we examine whether our main results are influenced by the level of capital market development. We use the ratio of stock market capitalization to GNP per capita (both also obtained from La Porta et al (1998)) as a proxy for how developed a country s capital market is. We include it as an additional control variable in the estimation of equation (4). 23 Our result (unreported) shows that the coefficient c remains positive and significant (t-statistic = 5.02). Legal protection increases the sensitivity of corporate investment to stock prices, even after accounting for the level of capital market development. [Insert Table 5] To summarize, our findings highlight the important role that legal protection plays in the relationship between corporate investment and stock prices. In general, firms in countries with strong legal protection of investors have corporate investment that is more sensitive to stock prices than do firms in countries with weak legal protection. 23 The same variable is used by Dittmar et al. (2003) as a proxy for capital market development. They find that capital market development increases a firm s tendency to hold more cash. 22

24 4.2 The role of the equity-financing channel After finding that legal protection matters in the sensitivity of a firm s corporate investment to stock prices, we now explore the role of the equity-financing channel. As elaborated in the earlier section, we use the four-variable KZ index as our measure of equity dependence to test Hypotheses 2 and 3. We first assign firms to KZ quintile portfolios, where quintile 1 represents the portfolio of firms in the bottom 20% of the KZ scores. Correspondingly, quintile 5 represents the portfolio of firms in the top 20% of the KZ scores. Following Baker et al. (2003), the assignment of firms is based on the firm s median KZ scores over the whole sample period. 24 We then estimate the baseline investment equation (3) separately for each KZ quintile portfolio. As before, we estimate the fixed-effects model that controls for firm and year effects, with White s heteroskedasticity corrected robust standard errors (clustered by firms). Hypothesis 2 predicts that b increases with KZ quintiles. In other words, we conjecture that the sensitivity of corporate investment to stock prices should increase as the degree of equity dependence increases. Panel A of Table 6 present the estimation results of equation (3) for KZ quintile 1 to quintile 5, respectively. We observe that the coefficient b increases from in the bottom quintile to 0.02 in the top quintile, an increase of more than three times. Firms classified as more equitydependent display a larger sensitivity of investment to stock prices than do firms that are classified as nonequity-dependent. However, the coefficient f does not appear to display any meaningful pattern. The finding for our international sample is consistent with Hypothesis 2 and complements the finding by Baker et al. (2003) on a sample of U.S. firms. Hence, we interpret 24 Alternatively, we assign firms based on firm-year KZ scores and obtain similar results. 23

25 our result as supportive of the equity-financing channel as a potential explanation for the relationship between corporate investment and stock prices for international firms. [Insert Table 6 here] In terms of economic significance, one standard deviation change in Tobin s Q changes corporate investment by 0.5 to 1.8 percent. 25 The economic effect is quite sizeable, considering that the median corporate investment over the whole sample period is 4.7 percent. This analysis further suggests that the effect of stock prices on corporate investment outweighs that of cash flow for firms in the top KZ quintile (those that are considered to be most dependent on external equity). 26 This finding is again similar to that found by Baker et al. (2003) on a sample of U.S. firms. We also follow Baker et al. (2003) in reporting t-statistics that essentially test the hypothesis that the difference between the b coefficients in KZ quintiles 2 to 5 and that in KZ quintile 1 is zero. These t-statistics are obtained by estimating equation (3) on the five KZ quintiles simultaneously. Table 6 demonstrates that all the t-statistics are positive and highly significant at the one percent level. In particular, the t-statistic of the difference in coefficients of b between the top and bottom KZ quintiles is We further split our samples into equity-dependent and nonequity-dependent firms based on our three measures of equity-dependence: the (modified) KZ index, the original KZ index, and firm size (total book value of assets in U.S. dollars). Panel B reports the coefficients of Q obtained from estimating equation (3) for the two subsamples. We continue to find that the 25 For firms in the bottom KZ quintile, the change in corporate investment is (0.858*0.006) = 0.5 percent. Correspondingly, for firms in the top KZ quintile, the value is (0.858*0.020) = 1.7 percent. 26 For firms in the top KZ quintile, the effect of one standard deviation change in cash flow on corporate investment is (0.116*0.139) = 1.6 percent. 24