Corporate Governance and Capital Allocations of Diversified firms
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Corporate Governance and Capital Allocations
of Diversified firms
Sheng-Syan Chen, National Taiwan University
I-Ju Chen, Yuan Ze University
Taiwan
2008 NTU Conference on Finance
2008/12/11
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Introduction (1/2)
The problems of asymmetric information and agency have significant impacts on the efficiency of corporate investment.
(Jensen, 1986,1993; Stein, 2003; Bertrand and Mullainathan, 2003).
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Introduction (2/2)
Diversified firms have serious agency problems, such as:
Multi-tiered agency problems (Scharfstein and Stein, 2000) Power-bargaining activities (Rajan, Zingales, and Serves, 2000).
Lead to diversification discounts (Berger and Ofek, 1995; Shin and Stulz, 1998; Scharfstein and
Stein, 2000; Rajan et al., 2000).
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The Role of Governance Board: Fama and Jensen (1983) Ownership structure:
Morck, Shleifer, and Vishny (1988), McConnell and Servaes, (1990); Hermalin and Weisbach, (1988); etc.
Shleifer and Vishny (1986)
CEO compensation: Jensen and Meckling (1976); Jensen and Murphy (1990); Bizjak, Brickley, and Coles (1993)
Auditing role: Spira (1999);Healy and Palepu (2001) etc. Market for corporate control:
Gompers, Ishii, and Metrick (2003) Durnev and Kim (2005)
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Research Questions
If the governance is aimed to alleviate the agency problem, will we see the difference on the investment efficiencies of diversified firms with difference governance structure?
Will the better-governed diversified firms allocate their funds efficiently and have higher market valuations ?
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Hypothesis Statements
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Hypothesis Statements
H1 : Better-governed diversified firms are relatively more effective in investment allocations.
H2 : Better-governed diversified firms have relatively higher firm valuations for diversified firms.
H3 : Better-governed diversified firms are relatively more effective in investment allocations and hence have relatively higher firm valuations.
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Five Dimensions on Governance Mechanisms
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Five Dimensions on Governance Mechanisms (1/4)
Internal Governance
A. board characteristics
Category / Item Definitions Prediction References
board size number of directors +/-(-): Jensen (1993), Yermack (1996)
(+): Boone, Field, Jarpoff, and Raheja (2007)
(?): Lehn and Zhao (2006)
boardIndependence
fraction of outside directors
+(+) : Fama and Jensen (1983), Beasley Carcello, Hermanson, and Lapides (2000), Farber
(2005), Anderson, Bates, Bizjak, and Lemmon (2000 ); Boone, Field, Jarpoff, and Raheja(2007)
leadership structure
Dummy=1, if CEO is the chair of the board
+/-(+) : Fama and Jensen (1983), Jensen (1993), Lehn and Zhao (2006) (-) : Brickley, Coles, and Jarrell (1997)
busy boardfraction of the board’s directors hold three of more directorships
+/? (?): Ferris Jagannathan, and Pritchard (2003) (-): Fich and Shivdasani (2006)
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Five Dimensions on Governance Mechanisms (2/4)
Internal Governance
B. ownership structure
Category / Item Definitions Prediction References
insider ownership
percentage of common equity held by the officers and directors
+/-
(+) : Fama and Jensen (1983), Leland and Pyle (1977), Goergen and Renneboog (2001), Lehn and Zhao (2006),
(?) : Demsetz and Lehn (1985)
blockholder ownership
ratio of total more than 5% shareholdings to total common shares outstanding
+(+) : Shleifer and Vishny (1986), Shleifer and Vishny
(1997), Shome and Singh (1995), Allen and Phillips (2000)
institutional ownership
percentage of shares held by the 18 largest public pension funds
+
(+) : Bushee (1998), Gillan and Starks (2000), Pound (1988)-banks/insurance, Thomsen and Pedersen (2000)-financial investors, Cremers and Nair (2005)-pension funds and bank trust
(outside) director
ownership
percentage of common equity held by the outside directors
+ (+) : Jensen (1993), Yermack (2004)
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Five Dimensions on Governance Mechanisms (3/4)
Internal Governance
C. CEO compensation
Category / Item Definitions Prediction References
CEO equity-based
pay
ratio of equity-based compensation in CEO’s compensation package; where equity-based pay defined as the value of stock options and restricted stock grants
+
(+) : Fama and Miller (1972), Jensen and Murphy (1990), Bizjak, Brickley, and Coles (1993), Datta Lskandar-Datta, and Raman (2001), Anderson, Bates, Bizjak, and Lemmon (2000)
CEO ownership
percentage of common equity held by CEO
+/-
(+) : Jensen and Meckling (1976), Agrawal and Mandelker (1987), Kim et al. (1988), Lewellen et al., (1985, 1989), Morck et al. (1988), Anderson et al. (2000);
(?) : Demsetz and Lehn (1985)
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Five Dimensions on Governance Mechanisms (4/4)
Internal Governance
D. audit committee
Category / Item Definitions Prediction References
outside director on
audit committee
Dummy=1, if all audit committee members are outside directors
+(+) :Spira (1999), Carcello and Neal (2000), Klein (2002),
Beasley (1996), Bushman and Smith (2002)
number of audit
committee meetings
number of audit committee meetings per year
+(+) :McMullen and Raghunandan (1996), Beasley,
Carcello, Hermanson, and Lapides (2000)
E. market for corporate control
market for corporate
controlgovernance Index (GIM) -
(+): Jensen (1988), Scharfstein (1988), Jensen and Ruback (1993), Gompers et al. (2003), Dittmar and Mahrt-Smith (2007)
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Measuring investment allocations
Investment levels in individual segments: unadjusted investment (UIR)
= ratio of segment capital expenditures to segment sales.=
industry-adjusted investment (IAIR) = segment’s capital expenditure-to-sales ratio minus the median capital expenditure-to-sales ratio of single-segment firms in the same three-digit SIC industry.=
j
j
S
I
ssj
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j )S
I(
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Rajan et al. (2000)
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Investment levels in individual segments: industry and firm-adjusted investment (IFAIR)
= segment’s industry-adjusted investment minus the firm’s sales-weighted sum of industry-adjusted investment.
= = IAIR- firm’s sales- weighted sum of IAIR
= IFAIR
where : sales-weight for segment j
n
1j
ssj
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Measuring investment allocations
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Firm-level measures of investment efficiency
relative investment ratio (RINV)
Sj is the sales of segment j.
Wj is the sales of segment j divided by the firm total sales.
Ij is the capital expenditures of segment j.
is the capital expenditure-to-sales ratio of the median single-segment firm operating in the same three-digit SIC industry as firm j.
TS is the total sales of the firm.
For j =1…k, the firm’s segments have an industry median q greater than the firm’s sales-weighted average q, while j=(n-k+1)…n indicates that the firm’s segments have an industry median q less than the firm’s sales-weighted average q.
TS
SI
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Iw
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1111
ssjS
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IFAIR
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relative value added by allocation (RVA)
absolute value added by allocation (AVA)
TS
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IFAIR
IAIR
Firm-level measures of investment efficiency
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Studied Periods
Robust Check
Number of available governance / Compustat observations
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Selected Samples
Collect financial data from Compustat for all firms in fiscal year 2005.
Corporate governance data are collected from :RiskMetric (formerly IRRC) Directors datasets, Thomson Reuters (Institutional), Compustat Executive Compensation and Gompers, Ishii, and Metrick’s (2003) governance index. Insider ownership and blockholder ownership are hand
collected from SEC proxy statement.
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Sample Distributions (1/2)
Number of available Compustat observations (year=2005)
single-segment firms 3845
multi-segment firms
2-segment firms 433
3-segment firms 890
4-segment firms 600
5-segment firms 336
5+-segment firms 262
subtotal 2521
(Percentage) 39.6%
number of full samples 6366
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2020
Number of available governance observations (year=2005)
Board size 892
Board independence 892
Leadership structure 892
Busy board 892
Insider ownership 850
Blockholder ownership 834
Institutional ownership 2503
(Outside) director ownership 889
CEO equity-based pay 1042
CEO ownership 533
Outside director on audit committee 881
Number of audit committee meetings 881
Market for corporate control 1269
Sample Distributions (2/2)
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Descriptive StatisticsGovernance Characteristics Statistics by Firm Type
(Differences between multi- and single- segment firms)
Means Medians
Board size 0.83*** 1.00***
Board independence 2.78*** 3.57***
Leadership structure 0.08*** 0.00***
Busy board 4.22*** 11.11***
Insider ownership -2.17*** -2.05***
Blockholder ownership -5.20*** -6.76***
Institutional ownership 0.58*** 1.38***
(Outside) director ownership -0.15** -0.15***
CEO equity-based pay -0.07*** -0.09***
CEO ownership -0.04 0.04
Out. Dir. on audit Com. -0.04* 0.00*
No of audit Com. Meetings 0.35* 0.00
Market for corporate control 0.74*** 1.00***
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Research Design Investigate whether the efficiency in capital
allocations among divisions of diversified firms is associated with governance structure.
Study the role of governance mechanisms in terms of capital allocation efficiency in a multivariate framework.
Analyze the capital allocations within diversified firms under different governance structure.
Examine the relationship among the value discount, investment efficiency, and the governance structure.
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Investment Efficiency for Multi-segment Firms Stratified by Governance Mechanisms Allocation (1/2)
Panel A : RINVHigh value of
variablesLower value of
variables differences
mean median mean median mean median
Board size 0.0006 0.0000 0.0026 0.0009 -0.0020 -0.0009
Board independence 0.0081 0.0037 -0.0060 -0.0010 0.0141*** 0.0047***
Leadership structure -0.0012 -0.0001 0.0096 0.0025 -0.0108** -0.0026**
Busy board -0.0066 -0.0004 0.0090 0.0017-0.0156***
-0.0021***
Insider ownership 0.0006 -0.0003 0.0007 0.0007 -0.0001 -0.0010
Blockholder ownership 0.0028 0.0003 -0.0026 0.0003 0.0054 0.0000
Institutional ownership 0.0075 0.0014 -0.0083 -0.0013 0.0158*** 0.0027***
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Investment Efficiency for Multi-segment Firms Stratified by Governance Mechanisms Allocation (2/2)
Panel A : RINV
High value of variables
Lower value of variables differences
mean median mean median mean median
(Outside) director ownership 0.0082 0.0017 -0.0062 -0.0009 0.0144*** 0.0026***
CEO equity-based pay 0.0084 0.0020 -0.0046 -0.0007 0.0130*** 0.0027***
CEO ownership 0.0037 0.0006 -0.0006 -0.0003 0.0043 0.0009
Out. Dir. on audit Com. 0.0072 0.0014 -0.0091 -0.0003 0.0163*** 0.0017**
No of audit Com. Meetings 0.0093 0.0042 -0.0065 -0.0010 0.0158*** 0.0052***
Market for corporate control -0.0052 0.0002 0.0083 0.0009-0.0135***
-0.0007***
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Empirical Results
From univariate analysis, we get the preliminary results that diversified firms with following characteristics efficiently allocate their funds : higher board independence, Less board busyness, higher holdings of 18 public pension funds and
outside director ownership, higher quality of audit committee, and less takeover protection
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Research Design Investigate whether the efficiency in capital
allocations among divisions of diversified firms is associated with governance structure.
Study the role of governance mechanisms in terms of capital allocation efficiency in a multivariate framework.
Analyze the capital allocations within diversified firms under different governance structure.
Examine the relationship among the value discount, investment efficiency, and the governance structure.
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Model 1 2 3 4
GM Board sizeBoard
independenceLeadership structure
Busy board
Intercept 0.011 -0.027** 0.007 0.004
GM -0.001 0.001*** -0.011** -0.001***
inverseQ 0.005 0.001 0.005 0.001
Diversity -0.005 0.005 0.001 -0.005
Size 0.001 -0.001 0.001 0.001
Adjusted R2 -0.011 0.020 0.004 0.036
F-statistic 0.29 4.37*** 1.25 3.52**
N 263 263 263 263
Regression of Investment Efficiency (RINV)on Governance Mechanisms (1/3)
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Regression of Investment Efficiency (RINV)on Governance Mechanisms (2/3)
Model 5 6 7 8
GMInsider
ownershipBlockholder ownership
Institutional ownership
(Outside) director
ownership
Intercept -0.008 -0.012 -0.019*** -0.005
GM -0.001 0.001 0.005*** 0.006**
inverseQ 0.012 0.014 0.048*** 0.003
Diversity 0.019 0.020 0.006 0.004
Size 0.001 0.001 0.001 0.001
Adjusted R2 -0.004 -0.001 0.043 0.04
F-statistic 0.71 0.93 6.61*** 7.25***
N 292 283 501 262
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Regression of Investment Efficiency (RINV)on Governance Mechanisms (3/3)
Model 9 10 11 12 13
GMCEO equity-based pay
CEO ownership
Out. Dir. on audit Com.
No of audit Com.
Meetings
Market for corporate
control
Intercept -0.011* 0.005 -0.010 -0.014* 0.016*
GM 0.022*** 0.001 0.014*** 0.002*** -0.002***
inverseQ 0.016 0.001 0.002 0.004 0.032*
Diversity 0.001 -0.014 -0.001 0.002 -0.010
Size 0.001 -0.001 -0.001 -0.001 0.001
Adjusted R2 0.029 -0.025 0.014 0.015 0.023
F-statistic 6.28 0.26 11.95*** 8.00*** 9.94***
N 303 120 260 260 332
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Empirical Results
Whether the difference in firm investment efficiency is associated with the effectiveness in investment allocations among divisions of diversified firms under different governance structure ?
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3131
Research Design Investigate whether the efficiency in capital
allocations among divisions of diversified firms is associated with governance structure.
Study the role of governance mechanisms in terms of capital allocation efficiency in a multivariate framework.
Analyze the capital allocations within diversified firms under different governance structure.
Examine the relationship among the value discount, investment efficiency, and the governance structure.
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Allocation of Funds in the Diversified Firm Stratified by Gompers et al. (2003) Governance Index (GOV) (1/3)
Panel A : Full samples
High Q Low Q differences
mean median mean median mean median
Investment ratio (UIR) 0.0887 0.0211 0.1178 0.0308 -0.0291*-
0.0097***
Industry adjusted UIR (IAIR) 0.0353 -0.0058 0.0770 -0.0002 -0.0417**-
0.0056***
Industry & firm adjusted UIR (IFAIR) 0.0287 -0.0027 0.0667 -0.0001 -0.0380**-
0.0026***
Number of segments 1067 665
Number of firms 506 349
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Allocation of Funds in the Diversified Firm Stratified by Gompers et al. (2003) Governance Index (GOV) (2/3)
Panel B : High GOV samples
High Q Low Q differences
mean median mean median mean median
Investment ratio (UIR) 0.0536 0.0183 0.1282 0.0334-
0.0746***-
0.0151***
Industry adjusted UIR (IAIR) 0.0119 -0.0102 0.0804 0.0012-
0.0686***-
0.0114***
Industry & firm adjusted UIR (IFAIR)0.0070 -0.0069 0.0679 0.0003-
0.0609***-
0.0072***
Number of segments 677 437
Number of firms 329 230
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Allocation of Funds in the Diversified Firm Stratified by Gompers et al. (2003) Governance Index (GOV) (3/3)
Panel C : Low GOV samples
High Q Low Q differences
mean median mean median mean median
Investment ratio (UIR) 0.1495 0.0302 0.0977 0.0281 0.0518 0.0021**
Industry adjusted UIR (IAIR) 0.0761 0.0000 0.0704 -0.0032 0.0057 0.0032***
Industry & firm adjusted UIR (IFAIR) 0.0665 0.0000 0.0643 -0.0017 0.0022 0.0017***
Number of segments 390 228
Number of firms 177 119
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3535
Research Design Investigate whether the efficiency in capital
allocations among divisions of diversified firms is associated with governance structure.
Study the role of governance mechanisms in terms of capital allocation efficiency in a multivariate framework.
Analyze the capital allocations within diversified firms under different governance structure.
Examine the relationship among the value discount, investment efficiency, and the governance structure.
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Excess Value, Efficiency of Investments, & Corporate Governance
Excess Values
ModelHigh GOV index Low GOV index
1 2 3 4
Intercept -0.991*** -0.943*** -0.885*** -0.959***
RINV -1.248 8.020***
RVA -3.818 18.570***
InverseQ 1.650** 1.506** 1.541** 1.522**
CAPEX 4.792** 4.796** 7.977*** 6.573***
OPI 0.675 0.631 0.467 0.675
Herfindahl 0.153 0.122 0.316 0.410
Leverage 0.017 0.074 0.239 0.254
Size 0.002 0.002 0.000 0.001
Adjusted R2 0.106 0.103 0.372 0.383
F-statistic 8.42*** 8.35*** 8.71*** 9.25***
N 135 137 84 86
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Robust Check 1
investment efficiencies -
RINV: relative investment ratio
RVA: relative value added by allocation
AVA: absolute value added by allocation
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Robust Check 2
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Conclusions (1/2)
+
+
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Conclusions (2/2)
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Contributions
Complete investigation the role of governance in capital allocation among divisions of diversified firms.
Provide the empirical evidence that governance structure is crucial to the efficiencies of investment allocations among the divisions of diversified firms.
Comprehensively investigates the importance of each governance mechanism by linking to the capital allocations and valuations of diversified firms.
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Comments Welcome.