Post on 30-Jan-2023
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How do agency problems and information asymmetry moderate investment-cash
flow sensitivity- Evidence from China’s listed firms
Pei-Gi Shu*, Ya-wei Yang**, Yin-Hua Yeh***, and Shean-Bii Chiu****
* Graduate Institute of Business Administration, Fu Jen Caholic University
** Department of Finance and International Business, Fu Jen Catholic University
*** Institute of Finance, National Chiao Tung University
**** Department of Finance, National Taiwan University
Abstract
In this study we investigate the investment-cash flow sensitivity of the listed firms in
China and verify that investment is strongly sensitive to cash flow. We explore
whether this sensitivity is a result of agency problems that managers with high
discretion overinvest, or information asymmetry that market demands a high risk
premium to result in underinvestment. We use alternative variables of ownership
structure and board structure to capture agency problems and alternative variables to
capture information asymmetry. We find that investment-cash flow sensitivity results
mainly from agency problems embedded in variables of ownership structure and
board structure. Specifically, we find that the wedge between voting rights and cash
flow rights and state control accentuate investment-cash flow sensitivity, while
CEO/chairman duality and board size attenuate investment-cash flow sensitivity.
Moreover, the result is more saliently found in the subsample of firms with high cash
flow and low growth potentials. Finally, we contrast the impact of agency problems
on investment-cash flow sensitivity before and after share reform of the split share
structure. The result indicates that the moderating effect of agency problems is
heightened after the share reform.
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1. Introduction
In a perfect market a firm’s investment decisions should be independent from its
financial condition (Modigliani and Miller, 1958). However, the excess sensitivity of
investment to cash flow, initially documented by Fazzari, Hubbard, and Petersen
(1988), has triggered numerous academic attentions ever since. Literature exploring
the underlying factors is mainly in two threads: agency problems (e.g. Jensen and
Meckling, 1976; Grossman and Hart, 1982; Jensen, 1986) and information asymmetry
(e.g. Myers and Majluf, 1984; Greenwald, Stiglitz, and Weiss, 1984). The agency
problems indicate that owners-managers of levered firms tend to overinvest in risky
while negative-NPV projects due to their limited liability (Jensen and Meckling,
1976). The information asymmetry between firms and outside investors imply that
good investment opportunities many be forsaken because the costs of issuing
undervalued securities exceed the benefits from profitable project investments (Myers
and Majluf, 1984). A similar argument proposed by Stiglitz and Weiss (1981)
indicates that asymmetric information may result in the rationing of debt finance.
Prior studies tracing investment-cash flow sensitivity mainly focus on financing
constraint that is based on regressions of investment on cash flow and Tobin's Q.
However, challenges remain on the issue of how financial constraint is defined. For
example, Kaplan and Zingales (1997) use multiple qualitative and quantitative criteria
to define financial constraint and find firms that are less likely to be financially
constrained are associated with higher cash flow sensitivity. Kaplan and Zingales
(1997) and Hovakimian (2009) indicate that the sensitivity is non-monotonic with
respect to financial constraint. Another thread of studies illustrates the impact of
agency problems on investment-cash flow sensitivity. For example, Huang et al.
(2011) using the data from Chinese listed companies examine the effect of agency
cost on the relation between top executives' overconfidence and investment-cash flow
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sensitivity. They find that the positive effect of top executives' overconfidence1 on
investment-cash flow sensitivity holds only for companies that exhibit high agency
cost. Pawlina and Renneboog (2005) simultaneously include agency problems and
information asymmetry into examination and conclude that investment-cash flow
sensitivity results mainly from the agency costs of free cash flow.
In this study we also include both agency problems and information asymmetry
into the examination of investment-cash flow sensitivity. Alternative proxies were
used to serve as surrogates of agency problems and information asymmetry. More
importantly, we use both cash holdings and Tobin’s Q (a proxy of growth potentials)
to illustrate the condition that are specifically applied to the empirical test of agency
problems and of information asymmetry. If agency problems are the key issue to
result in a sensitive investment-cash flow relation, the sensitivity is expected to be
more saliently found in firms with high internal cash holdings and low Tobin’s Q. In
contrast, if information asymmetry are the key issue, the sensitivity is applied to firms
with low internal cash holdings and high Tobin’s Q.
The reasons why we choose China’s listed firms as our sample for the
investigation of investment-cash flow sensitivity are elaborated as follows. First, the
majority of China’s listed firms had been centrally controlled by the government and
then were transformed into or established as state owned enterprises (SOEs), where
the government held a majority of firms' shares and therefore served as the controlling
owner. Due to inadequate internal governance mechanisms and an ineffective market
1 Another thread of studies illustrate that managerial overconfidence could result in investment-cash
flow sensitivity even without invoking any assumptions on agency cost and information asymmetry
(Heaton, 2002). That is, overconfident managers increase their investment sensitivity to cash flow
under the belief that market undervalues the firm's projects and that the cost of external finance is too
high. Malmendier and Tate (2005) use managers’ personal portfolio in firms to serve as proxies of
managerial overconfidence. They find that overconfident managers show significantly higher
investment sensitivity to free cash flow, particularly for equity-dependent firms. Lin et al. (2005) find
the sensitivity is more salient for financing constrained firms. Nevertheless, this thread of studies relies
crucially on finding convincible surrogates of managerial overconfidence that is not readily observable.
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of corporate control, the government plays an important role in affecting firm’s
investment in the sense that state control associated with severe agency problems (Qi
et al., 2000) is expected to heighten investment-cash flow sensitivity. Second, China’s
economic modernization was in tandem with its share reform which gradually
transformed state controlled mechanism into market mechanism. The share reform
provides a splendid forum to contrast the impact of agency problems on
investment-cash flow sensitivity before and after the share reform. Third, the issue of
wealth expropriation from minority shareholders is more relevant in economies with
weak legal protection or poorer governance structure (La Porta et al., 1999, 2000;
Johnson et al., 2000; Peng et al., 2011). The ownership structure of China’s listed
companies is characterized as highly concentrated and the ultimate shareholder
usually has effective control. The unique characteristics of China’s listed firms could
be further incorporated in the research design.
Our investigation of the investment-cash flow sensitivity of the listed firms in
China could be easily summarized as follows. First, a strong link between firm’s
investment and cash flow is verified. Second, the investment-cash flow sensitivity
results mainly from agency problems embedded in ownership structure and board
structure than information asymmetry. Specifically, we find agency problems
accentuate the investment-cash flow relation particularly for the subsample of high
cash flow and low Tobin’s Q when agency problems are severe. In contrast, the
impact of information asymmetry on the investment-cash flow relation was not found
for the subsample of low cash flow and high Tobin’s Q where information asymmetry
is severe. For the variables of agency problems we find that the wedge between
voting rights and cash flow rights and state control accentuate investment-cash flow
sensitivity, while CEO/chairman duality and board size attenuate investment-cash
flow sensitivity. Finally, we contrast the impact of agency problems on
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investment-cash flow sensitivity before and after share reform and find that the
moderating effect of agency problems is heightened after the share reform.
This study bears some resemblances to previous studies. First, Pawlina and
Renneboog (2005) also explore how information asymmetry and agency cost affect
the investment-cash flow relationship. They use ownership and control patterns to
capture agency cost, and the impact of technical efficiency to capture information
asymmetry. They drew a similar conclusion with ours that investment-cash flow
sensitivity results mainly from the agency costs though our proxies of agency costs
contain some ownership structure variables that pertain to China, namely, wedge, state
control, CEO/chairman duality, and board size. Huang, Jiang, Liu, and Zhang (2011)
use the data from China’s listed firms to explore the effect of agency cost on the
relation between top executives' overconfidence and investment-cash flow sensitivity,
and conclude that the positive impact of executives' overconfidence on
investment-cash flow sensitivity only sustains for state-owned entities but not for
non-state controlled firms. Using the ratio of managerial expenses to total assets to
serve as a proxy of agency cost they find that the investment distortion due to top
executives' overconfidence behavior may be alleviated by reducing agency cost
through elevated supervision. In contrast, we use four variables to capture agency
problems and conclude a similar story that agency cost accentuates the positive
investment-cash flow relationship. However, we additionally cover information
asymmetry and illustrate conditions that would be differently applied to agency cost
and information asymmetry in moderating the investment-cash flow relationship.
Another similar finding is found in Kuo and Hung (2012) who use the sample of
Taiwan’s listed firms and find that excess control rights and board independence
moderate the relationship between family control and investment-cash flow
sensitivity.
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The potential contributions of this paper are multifold. First, we revisit the issue of
investment-cash flow sensitivity by using the data of the listed firms in China that is
characterized as weak in investor protection and illiquid in market trading. An
emerging market that exhibits severe agency problems and information asymmetry
makes it a splendid forum to revisit the issue. Second, we do not only identify the
proxy variables relating to the special attributes of China but also identify conditions
that would separately better fit for the test of how agency problem affects the
investment-cash flow sensitivity and for the test of how information asymmetry
affects the investment-cash flow sensitivity. Third, as most listed firms in China have
been through share reform that corrects the split-share structure, we explore the issue
of how share reform affects the moderating effect of agency problems on
investment-cash flow sensitivity. We find that the moderating effect is applied more to
the sample after share reform than the sample before share reform. This implies that
the share reform transforming into market mechanism sharpens the moderating effect
of agency costs on investment-cash flow sensitivity. The rest of this paper is
organized as follows. Section 2 is literature review and hypothesis development.
Section 3 depicts the data, variables, and empirical models. Section 4 reports the
empirical findings. Section 5 concludes.
2. Literature Review and Hypothesis Development
2.1. Agency Problems and Investment-Cash Flow Sensitivity
In a perfect market without agency problems, external funds provide a perfect
substitute for internal funds and that makes firm's investment decisions independent
of its financial condition. However, in the presence agency costs a firm’s investment
is affected by changes in its net worth or internal funds, holding constant investment
opportunities (Hubbard, 1998). In this study we include four variables to illustrate
how agency problems affect the investment-cash flow sensitivity. The first variable is
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the wedge between cash flow and control rights. Prior studies indicate that the wedge
negatively affects firm value (Claessens et al., 2002; Lemmon and Lins, 2003; Laeven
and Levine, 2008; Gompers et al., 2010). The wedge mainly through the common
practice of cross shareholdings and pyramidal structure allows controlling owners to
exercise excess control despite having relatively small proportional cash flow rights.
Therefore, the wedge gives controlling owners an incentive to pursue their own
interests at the expense of the wealth of other investors (Chen et al., 2011). Moreover,
the wealth expropriation is especially relevant in economies with weak legal
protection or poorer governance standards (La Porta et al., 1999, 2000; Johnson et al.,
2000; Peng et al., 2011). We therefore expect to find that the wedge positively
moderates the investment-cash flow relation.
The second variable is state control. This is common attribute for many
transitional economies where government has a profound impact on how the firms
operate. Many Chinese listed companies have the state, a state agency, or city or
regional government as the controlling shareholder. The debate remains as to whether
state control is a reason for the poor efficiency (Allen et al., 2005; Chen et al., 2009).
One of reasons why state control could have a positive impact on investment-cash
flow sensitivity is because government has multiple socio-economic objectives so that
some not-that promising investments would still be taken suffice that the perceived
marginal benefits exceed the marginal costs. Firth et al. (2012) indicate that the listed
firms under government control are associated with greater investment-cash flow
sensitivities than do privately controlled listed companies. Moreover, the difference in
sensitivities appears only in firms with few profitable investment opportunities.
The third variable is CEO/chairman duality. Jensen (1993) indicates that
chairman-CEO duality gives the CEO excessive power over the decision-making
process and therefore fails internal control systems. It is therefore suggested that good
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corporate governance in the UK separates the two roles (Cadbury, 1992). However,
the case applied to China’s listed firms is somewhat different. First, China’s corporate
governance is relatively weak and many firms are subject to insider control. The
CEO/chairman duality increases the possibility of power concentration and therefore
gives CEOs more negotiation power. Second, some empirical findings of China
support for a positive relationship between CEO duality and firm performance (Tian
and Lau, 2001). Because CEO duality is associated with better performance and
therefore lower likelihood of CEO turnover, CEOs simultaneously chairs the board
would be somewhat exonerated from the burden of short-term performance and
therefore a lower inclination of overinvestment. We therefore postulate that
CEO/chairman duality is expected to attenuate the investment-cash flow sensitivity.
The fourth variable is board size. There are two opposing arguments relating to
board size. From the perspective of agency theory, large boards are usually associated
with ineffective monitoring and poor coordination (Jensen, 1993; Lipton and Lorsch,
1992). In contrast, the resource dependence theory indicates that large boards provide
greater access to outside recourses, expertise, industry experience, and legitimacy
(Pfeffer, 1972; Zahra and Pearce, 1989). Moreover, guanxi referring to the durable
social connections and networks a firm uses to exchange favors for organizational
purposes is a special attribute of China’s listed firms (Gu, Hung, and Tse, 2008). Xin
and Pearce (1996) indicate that guanxi could serve as a substitute for formal
institutional support since it goes deep as a governance mechanism and even
dominates business activities throughout China. In this sense, board size could
attenuate the investment-cash flow relation.
In general, we would expect to find that variables of agency problems would
accentuate the investment-cash flow relation. Moreover, the close tie due to agency
problems implies the overinvestment on negative-NPV projects, we would expect to
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find that the moderating effect of agency problems would be more saliently found in
condition that firms with high cash holdings while low growth opportunity.
Hypothesis 1: Agency problem accentuates the investment-cash flow sensitivity and
the tightened sensitivity is more saliently found in firms with high cash
holdings while low growth potentials.
2.2. Information Asymmetry and Investment-Cash Flow Sensitivity
In a perfect market without frictions Modigliani and Miller (1958) postulate that a
firm’s investment decisions should be independent from its financing decisions.
Numerous studies indicate that information asymmetry results in costly external
financing because it contains a “lemons” premium (e.g., Myers and Majluf, 1984;
Amihud and Mendelson, 1988; Brennan and Subrahmanyam, 1996; Easley and
O’Hara, 2004). Fazzari et al. (1988) indicate that the investment of firms that have
exhausted internal funds would become more sensitive to the fluctuations of their cash
flows. Cleary et al. (2007) present a theoretical model that predicts that firms facing
greater asymmetric information problems would be associated with greater
investment-cash flow sensitivity.
Fazzari et al. (1988) use low-dividend payout as the proxy of financial constraint,
and argue firms with low-dividend payout should have higher investment-cash flow
sensitivity. Kaplan and Zingales (1997) indicate that dividend policy is a choice
variable and might not directly relate to financial constraint. Instead, they use
qualitative and quantitative information from financial statements to classified firms
into three categories: never constrained, likely constrained, and constrained. However,
they find that the investment-cash flow relation is less sensitive for likely- constrained
firms than for never-constrained firms, therefore whether the investment-cash flow
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sensitivities provide a good measure of financing constraint was questioned (e,g,
Kaplan and Zingales, 1997, 2000). Consistent with Kaplan and Zingales (1997),
Cleary (1999) also finds the investment-cash flow relation is most sensitive for firms
being classified in the most credit-worthy group. Cleary et al. (2007) try to reconcile
the seemingly irreconcilable findings of Fazzari et al. (1988) with those of Kaplan and
Zingales (1997, 2000) by arguing that some firms being classified as constrained
firms with the classification based on measures of information asymmetry are in
general not distressed.
Since information asymmetry remains a primary cause of financial constraints and
higher external capital costs, we use alternative measures of asymmetric information
to explore the moderating effect of information asymmetry on the investment-cash
flow relation. The first variable is big 4 auditors that are demanded because greater
assurance is seen to reduce information asymmetry (Carey, Simnett, and Tanewski,
2000; DeFond, 1992; Knechel, Niemi, & Sundgren, 2008). The second variable is
illiquidity measured by the average across stocks of the daily ratio of absolute stock
return to dollar volume. Aminud (2002) indicates that expected market illiquidity
positively affects ex-ante stock excess return, suggesting that expected stock excess
return partially reflects an illiquidity premium. Kaplan and Zingales (1997) indicate
that the degree of financial constraints affecting the sensitivity of investment to
changes in liquidity is ambiguous. Almeida and Campello (2002) argue that an
increase in liquidity will relax the constraints less for more constrained firms. We
postulate that firms have more liquid balances would be associated with lower
investment-cash flow sensitivity. This is because firms are less likely to be financially
constrained in the future if the liquid balances can be carried into future periods. The
third variable is discretionary accruals, as estimated using the modified Jones model
(Dechow et al., 1995). Most of the studies regarding information disclosure indicate a
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negative relation between disclosure quality and information asymmetry (e.g. Brown
and Hillegeist, 2007, Healy et al., 1999, Heflin et al., 2005 and Welker, 1995). As the
discretionary accruals increase, the firm becomes less transparent, and therefore the
information between firm and investors increases. The fourth variable is share
turnover which is computed as the mean daily trading volume scaled by shares
outstanding during the fiscal year (e.g., Leuz and Verrecchia, 2000), suggesting that
higher values of share turnover indicate more transparency and less opacity.
Since information asymmetry is a key to result in a close investment-cash flow tie,
we would expect to find that variables of information asymmetry would accentuate
the investment-cash flow relation. Moreover, the close tie due to information
asymmetry implies underinvestment or renouncement of profitable projects. The
condition is more saliently found in condition that firms with low cash holdings while
high growth opportunity.
Hypothesis 2: Information asymmetry accentuates the investment-cash flow sensitivity
and the tightened sensitivity is more saliently found in firms with
low cash holdings while high growth potentials.
2.3. Share Reform and Investment-Cash Flow Sensitivity
Share reform initially launched by the Chinese authorities in 2005 aimed at
eliminating non-tradable shares. The reform obliged the non-tradable shareholders to
compensate the tradable shareholders for gaining transferability. The reform is
deemed an advancement of the privatization process and an improvement on
corporate governance which in turn should enhance the value of the firm (e.g. Doidge
et al., 2007; Gompers et al., 2003). Furthermore, the reform increases the supply of
tradable shares and therefore has a positive effect on liquidity (see Amihud, 2002;
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Pastor and Stambaugh, 2003; Acharya and Pedersen, 2005). Overall, the reform
moves the capital market toward market mechanism. We therefore postulate that the
impact of agency problems or information asymmetry on the investment-cash flow
sensitivity would be much salient after share reform than before share reform.
Hypothesis 3: The impact of agency problems or information asymmetry on the
investment-cash flow sensitivity would be much salient after share
reform than before share reform.
3. Data, Variables, and Models
Our sample covers Chinese companies listed on both Shanghai and Shenzhen
stock exchanges during the period of 2003 to 2012. Financial firms and loss-making
firms in the process of delisting (i.e. being noted as special treatment) were excluded
from the sample. Moreover, the final sample was winsorized at 1% to ameliorate the
impact of extreme observations. The final sample contains 2,255 listed firms and
13,486 firm-year observations. The subsample of firms that have involved in share
reform consist 1,243 listed firms and 10,623 firm-year observations. The data was
jointly collected from the China Stock Market Trading Database (CSMAR) and
Taiwan Economic Journal (TEJ).
Table 1 reports the summary statistics of the variables. The dependent variable is
firm’s investment normalized by the beginning capital stock (I/K). On average, the
investment is 0.0712. The independent variable of cash flow is defined as income
before extraordinary items plus depreciation and amortization normalized by the
beginning capital stock (Cash/K). The average cash flow is 0.2011.
For agency problems, we include four variables. Wedge (wedge) is the difference
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between controlling owner’s control rights and cash flow rights2. The average wedge
is 0.0596. Board size (board size) is measured as the natural logarithm of number of
board membership. Duality (duality) is a dummy that is assigned the value of 1 when
CEO simultaneously chairs the board and 0 otherwise. On average, 16.45% of the
listed are associated with CEO/chairman duality. State control (state) is a dummy that
is assigned the value of 1 when the listed firm is ultimately controlled by the
government and 0 otherwise. The sampling firms comprise 57.85% of state-control
firms.
For information asymmetry, we also include four variables. Big 4 auditor (big 4)
is a dummy that is assigned the value of 1 when the listed firm’s accounting report is
attested by the big 4 auditors (Deloitte, PwC, Ernst & Young, and KPMG) and 0
otherwise. Only 6.11% of the sampling firms having their financial reports attested by
the big 4 auditors. Discretionary accrual (DA) is measured by the modified Jone’s
model as follows:
TACt = αt (1/TAt–1) + βt (ΔSALESt – ΔARt) + γt PPEt + ζt ROAt–1 + εt, … (1)
where TACt denotes total accruals in year t, calculated using the statement of cash
flow approach recommended by Hribar and Collins (2002) as income before
discontinued operations and extraordinary items less cash from operations and
discontinued operations and extraordinary items from the statement of cash flows);
TAt–1 denotes total assets at the end of year t-1; ΔSALESt denotes the change in sales
revenue between year t and year t-1; ΔARt denotes the change in accounts receivable
between year t and year t-1; PPEt denotes the gross amount of property, plant and
equipment at the end of year t; and ROAt–1 denotes return on assets in year t-1,
calculated as the ratio of income before discontinued operations and extraordinary
2 The defintion of control rights and cash flow rights refers to La Porta et al. (1999) and Claessens et al.
(2002). Control rights are the sum of the weakest link in the chain of ownership. Cash flow rights are
the sum of the product of ownership stakes along each chain of ownership.
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items to total assets. We note that TACt, ΔSALESt, ΔARt, and PPEt are scaled by
lagged total assets (TAt–1). The average discretionary accrual is 0.0645. Illiquidity
(Illiq), referred to Aminud (2002), is defined as the daily ratio of absolute stock return
to its dollar volume, averaged over the sampling period. On average the illiquidity is
0.0026.
⁄ ∑| |
, (2)
Where denotes the number of trading days for stock i in year t, | |
denotes the absolute return for stock i in year t, and denotes the dollar
volume which is the multiplication of price and trading volume for stock i in year t.
Finally, turnover (turnover) is defined as measured by daily trading divided by
outstanding shares.
∑
⁄ , (3)
For control variables, Tobin’s Q (Q), referred to Chung and Pruitt (1994), is
defined as follows.
) ) ) ) ) )
) , (4)
where MV(X) and BV(X) indicate the market and book variable of the argument
X, respectively. CS is common stock, PS is preferred stock, LTD is long-term debt,
INV is inventory, CL is capital leases, CA is current assets, and TA is total assets. The
average Tobin’s Q is 1.3665. Firm size (firm size) being defined as the natural
logarithm of firm’s assets is 9.3636 on average. Firm age (firm age) is defined as the
natural logarithm of the time lapse in months since the inception of the firm. Leverage
(lev) being defined as the ratio of total debt to total assets is 0.4881 on average.
The empirical model is specified as follows.
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(
)
(
) , (5)
Where Agency denotes the proxies for agency problems (including wedge, board
size, duality, and state control), and IA denotes the proxies for information asymmetry
(including big-4 auditor, discretionary accruals, illiquidity, and turnover). In this
equation, the most important ones, and , are expected to be positive, implying
that agency problems and information asymmetry attentuate the investment-cash flow
relation.
<<Insert Table 1 Here>>
4. Empirical Findings
Table 2 reports the Pearson correlation coefficients among variables. The result
indicates that firm’s investment is strictly connected with its cash flows, with the
correlation coefficient of 0.115 and significant at 1% level. Moreover, a firm’s
investment is positively correlated with board size, assets, state control, attestation by
big 4 auditors, discretionary accruals, and turnover, while is negatively correlated
with duality, Tobin’s Q, firm age, leverage, and illiquidity measure.
<<Insert Table 2 Here>>
In Table 3 we explore the impact of governance variables (which imply agency
problems) on investment cash flow relation. The result from model 1 indicates that
wedge is negatively correlated with firm’s investment (-0.0437), significant at 1%
level. More importantly, the interaction between wedge and cash flow is 0.2738,
significant at 1% level. This support prior findings that wedge is negatively affects
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firm value (Claessens et al., 2002; Lemmon and Lins, 2003; Laeven and Levine, 2008;
Gompers et al., 2010), a proxy of controlling owner’s wealth expropriation (Chen et
al., 2011), and particularly relevant in economies with weak legal protection or poorer
governance standards (La Porta et al., 1999, 2000; Johnson et al., 2000; Peng et al.,
2011). The significance of the moderating effect prevails across different model
specifications. More importantly, we find that the regression coefficient of the
interative term is higher for all the subsample comprising firms with high cash flow
and low Tobin’s Q (0.8216 in model 4) than for the full sample (0.2807 in model 3)3.
That is, the impact of wedge on investment-cash flow relation is more saliently found
for the subsample of firms confronting severe agency problems.
In model 2 we include state control in the regression and find that state-controlled
firms are associated with higher investment-cash flow sensitivity. The interactive term
of state control and cash flow is 0.0296, significant at 5% level. This is consistent
with prior findings of Qi et al. (2000) that government plays an important role in
affecting firm’s investment, and of Firth et al. (2012) that the listed firms under
government control are associated with greater investment-cash flow sensitivities than
do privately controlled listed companies.
In model 3 we include CEO/chairman duality and its interaction with cash flow
into the regression analysis. The result indicates that firms whose CEO
simultaneously chair the boards are associated with higher investment. However, the
interaction between duality and cash flow is significantly negative, indicating that
3 We use F test to verify whether the regression coefficients are significantly different in different
sample compositions and model specifications. The F statistics is specified as ) ⁄
) )⁄,
where RSSfull and RSSsub denotes residual sum of square for the full sample and subsample, respectively.
K denotes the number of parameters.
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CEO/chairman duality attenuates the positive investment-cash flow relation. The
finding is inconsistent with the findings from the western societies (e.g. Jensen, 1993;
Cadbury, 1992), while is consistent with the findings using the forum of China. For
example, Tian and Lau (2001) find that CEO/chairman duality is positively correlated
with firm performance for the listed firms in China. If this is the case, firms with
CEO/chairman duality are less likely to be replaced due to better performance. These
CEOs are therefore less burdened with short-term performance and therefore a lower
inclination of overinvestment. Our empirical finding basically supports this
postulation in the sense that the interaction between duality and cash flows is
significantly negative for the full sample (-0.0616), and the moderating effect of
CEO/chairman duality is more pronounced for the subsample of high-cash and low-Q
firms in which agency problems are severe (-0.1133).
In model 4 we include board size and find that board size attenuates the positive
investment-cash flow relation. The regression coefficient of the interaction between
board size and cash flows is -0.1491, significant at 5% level. Again, this finding is
inconsistent with the findings or postulations from the western societies (e.g. Jensen,
1993; Lipton and Lorsch, 1992). Our finding probably resembles the argument that
board size implies guanxi that is durable social connections and networks (Gu, Hung,
and Tse, 2008) and therefore serves as substitution for formal governance mechanism
(Xin and Pearce, 1996). However, the moderating effect of board size is insignificant
for the subsample of high-cash and low-Q firms.
For the control variables, we find that Tobin’s Q is positively correlated with
investment. This is consistent with setting of Fazzari, Hubbard, and Petersen, (1988)
and previous findings (e.g. Fazzari, Hubbard, and Petersen, 1988; Hoshi, Kashyap,
and Scharfstein, 1991; Lamont, 1997). We find that firm size is positively correlated
with investment. This is consistent with prior finding that larger firms are associated
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with lower transaction costs and are less susceptible to information asymmetry effects
(e.g. Zarzeski, 1996). Firm age is negatively correlated with investment. Prior studies
(e.g., Rauh, 2006; Brown et al., 2009) indicate that firm age is strongly correlated
with asymmetric information problems and has been used as a proxy for the presence
of financing frictions. Finally, we find that leverage is negatively correlated with
investment, which is consistent with Habib and Ljungqvist (2005).
In general, our first hypothesis that agency problem accentuates the
investment-cash flow sensitivity receive supporting evidence from the listed firms in
China. Specifically, wedge and state control accentuate while CEO duality and board
size attenuate the positive investment-cash flow relation. Moreover, the moderating
effect of agency problem embedded in corporate governance is more pronounced in
the subsample of firms with high cash holdings while low growth potentials.
<< Insert Table 3 Here>>
In Table 4 we investigate how information asymmetry affect investment-cash
flow relation. The proxy variables for information asymmetry include big-4-auditor
dummy, discretionary accruals, illiquidity measure, and turnover. In model 1 we
include big-4 dummy and discretionary accruals. The result indicates that
discretionary accruals heighten the investment-cash flow relation because firms with a
high level of discretionary accruals are negatively associated with disclosure quality
and therefore a higher level of information asymmetry (e.g. Brown and Hillegeist,
2007, Healy et al., 1999, Heflin et al., 2005 and Welker, 1995). The interaction
between big-4 dummy and cash flow is positive, albeit insignificant.
In model 2 we include illiquidity measure, turnover, and their interaction with
cash flow. The result indicates that illiquidity measure accentuates while turnover
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attenuates the investment-cash flow relation. The moderating effect of illiquidity
measure supports Almeida and Campello’s (2002) argument that an increase in
liquidity will relax the constraints less for more constrained firms. The moderating
effect of turnover is in supportive to Leuz and Verrecchia (2000) in the sense that
higher values of share turnover indicate more transparency and less opacity. In model
3 we include the four proxy variables of information asymmetry and find the result
basically intact. In general, the empirical results for the full sample lend support to the
postulation that information asymmetry has a positive impact on the investment-cash
flow relation.
However, if information asymmetry is the key to drive investment-cash flow
sensitivity, we would expect to find that the moderating effect of information
asymmetry is applied more to the condition of financial constraint. We use the
subsample of low cash flow and high Tobin’s Q as the proxy for financial constraint.
Unfortunately, the subsample fails to provide a more promising picture of the
moderating effect of information asymmetry on the investment-cash flow relation. In
general, we do find that information asymmetry positively moderate the
investment-cash flow relation. However, the moderating effect of information
asymmetry is insignificant for the subsample of financially constrained firms.
In general, our second hypothesis receives partial support from the empirical
evidence: the part that information asymmetry accentuates the investment-cash flow
sensitivity is supported while the part that the tightened sensitivity is more saliently
found in firms with low cash holdings while high growth potentials is unsupported.
<<Insert Table 4 Here>>
In Table 5 we contrast the moderating effect of agency problem before and after
20
share reform. The literature of split-share reform indicates that the share reform
increases market liquidity (Amihud, 2002; Pastor and Stambaugh, 2003; Acharya and
Pedersen, 2005) and improves corporate governance (e.g. Doidge et al., 2007;
Gompers et al., 2003). More importantly, Liao, Liu, and Wang (2014) indicate that the
reform adopted a market mechanism that played an effective information discovery
role in aligning the interests of the government and public investors. We therefore
assume that the reform is a milestone moving the capital market toward market
mechanism, and therefore expect that the moderating effect of agency problems is
more pronounced after than before the share reform. The result in Table 5 verifies this
postulation by showing that wedge positively moderates while CEO/chairman
negatively moderates the investment-cash flow sensitivity. In contrast, board size is
significant in moderating the investment-cash flow relation before share reform, and
becomes insignificant after the share reform. This could be explained that as the
market moves toward market mechanism, the facilitation of board connection in
alleviating financial constraint was effectual before the share reform while ineffectual
after the share reform.
We also conduct the test whether the moderating effect of information
asymmetry is more significant for the subsample after the share reform than before
the share reform. The result (unreported) fails to illustrate any significant contrast
between samples in the two sub-periods. Therefore, our third hypothesis receives
partial support that the impact of agency problems on the investment-cash flow
sensitivity is much salient after share reform than before share reform.
<<Insert Table 5 Here>>
5. Concluding Remark
21
This paper investigates the investment-cash flow sensitivity of using a sample of
firms listed of China. In general, we confirm earlier findings that investment is strictly
tied to cash flow. Moreover, we find that a cash flow-dependent investment policy
results mainly from agency problems. The significantly positive relationship between
investment-cash flow sensitivity is moderated by the wedge between controlling
owner’s voting rights and cash flow rights, state control, CEO/chairman duality, and
board size. Moreover, the moderating effect of agency problems is more saliently
found for the subsample of firms with high cash flows and low growth potentials.
Secondly, we find that the positive investment-cash flow relation is also moderated by
information asymmetry using the proxies such as big-4 auditors dummy, discretionary
accruals, illiquidity measure, and stock turnover. The result basically supports the
argument that information asymmetry sharpens the linkage between investment and
cash flows. However, we fail to find that the moderating effect of information
asymmetry is more pronounced for the subsample consisting firms with low cash
flows and high growth potentials. Finally, we find that the moderating effect of
agency problems is more salient after share reform than before share reform.
The results of this paper indicate that the agency costs of free cash flow appear to
be the main source of the investment-cash flow sensitivity of the UK listed
corporations in the post-Cadbury period. Therefore, from a policy perspective, it
seems essential to pursue the further alignment of interests of managers and
shareholders by stimulating effective shareholder monitoring and
pay-for-performance schemes.
Furthermore, our results indicate promising avenues for future research. First, one
can attempt to incorporate managerial remuneration and turnover in the investment
model to analyze to what extent the disciplining devices have already translated into
efficient investment policies. Second, an interesting research opportunity is to analyze
22
the changes in the cash flow sensitivity of investment in the aftermath of (voluntary)
changes in corporate disclosure.
23
Brown, J.R., Fazzari, S.M., Petersen, B.C., 2009. Financing innovation and growth: Cash flow, external
equity and the 1990s R&D boom. Journal of Finance, 64 (1), 151-185.
Cadbury, A. (1992). A report of the committee on the financial aspects of corporate governance.
London: Gee.
Doidge, C., Karolyi, G.A., Stulz, R., 2007. Why do countries matter so much for corporate governance?
Journal of Financial Economics 86, 1–39.
Gompers, P.A., Ishii, J.L., Metrick, A., 2003. Corporate governance and equity prices. Quarterly
Journal of Economics 118, 107–155.
Gu, F. F., Hung, K., and Tse, D. K. 2008. When does Guanxi matter? Issues of capitalization and its
dark sides. Journal of Marketing, 72, 12-28.
Habib, M. A. and Ljungqvist, A. P., 2005. Firm value and managerial incentives: A stochastic
frontier’, Journal of Business, 78 (6), 2053-2094.
Leuz, C., Verrecchia, R.E., 2000. The economic consequences of increased disclosure. Journal of
Accounting Research 38, 91–124.
Liao, Liu, and Wang, 2014. China's secondary privatization: Perspectives from the split-share structure
reform, Journal of Financial Economics, forthcoming.
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pension plans. Journal of Finance 61, 33–72.
Tian, J.J., Lau, C., 2001. Board composition, leadership structure and performance in Chinese
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disclosures practices. Accounting Horizons 10 (1), 18-37.
24
Table 1: Summary Statistics
Investment ratio (I/K) is investment scaled by beginning capital stock. Cash flow ratio (Cash/K) is cash
flow scaled by beginning capital stock. Wedge (Wedge) denotes the discrepancy between controlling
owner’s voting rights and cash flow rights. Board size (Board size) is measured by the natural
logarithm of the number of board members. Duality (Duality) is a dummy that is assigned the value of
1 when the CEO simultaneously chairs the board and 0 otherwise. The state dummy (State) is assigned
the value of 1 when the firm is ultimately controlled by the State and 0 otherwise. The audit quality is
measured by the big-4 dummy (Big4) that is assigned the value of 1 when the firms is attested by
auditors in the big 4 auditing firms and 0 otherwise. Earnings quality is measured by discretionary
accruals from the modified Jone’s model. Illiquidity measure, referred to Aminud, is defined as the
daily ratio of absolute stock return to its dollar volume, averaged over some period. Turnover
(Turnover) is measured by daily trading divided by outstanding shares. Tobin’s Q (Q) is measured by
Chung and Pruitt (1994) at the beginning of the period t. Firm size (Firm Size) is the natural logarithm
of beginning total assets. Firm Age (Firm Age) is the natural logarithm of the time lapse since inception.
Leverage (Lev) is the total debt scaled by beginning total assets.
Variable Mean Q1 Median Q3 S.D.
I/K 0.0712 0.0087 0.0401 0.1005 0.0712
Cash/K 0.2011 0.0848 0.1525 0.2678 0.2011
Wedge 0.0596 0 0 0.1138 0.0596
Board size 0.9551 0.9542 0.9542 1 0.0903
Duality 0.1645 0 0 0 0.3708
State 0.5785 0 1 1 0.4938
Big4 0.0611 0 0 0 0.2395
DA 0.0645 -0.1599 0.0339 0.2332 0.6959
Illiq 0.0026 0.0005 0.0010 0.0028 0.0040
Turnover 0.2737 0.0777 0.1735 0.3665 0.2915
Q 1.3665 0.8016 1.0333 1.5371 0.9821
Firm Size 9.3636 9.0151 9.3114 9.6516 0.5176
Firm Age 0.8221 0.6021 0.9031 1.0792 0.3513
Lev 0.4881 0.3283 0.4892 0.6314 0.2327
25
Table 2: Pearson Correlation Coefficients
This table reports the Pearson’s correlation coefficients among variables being defined in Table 1. ***, **, and * denotes the significance level of 1%, 5%, and 10%,
respectively.
I/K Cash/K Wedge Board Size Duality Q Firm Size Firm Age Lev State Big4 DA Illiq Turnover
I/K 1.000
Cash/K 0.115*** 1.000
Wedge -0.008 -0.015* 1.000
Board Size 0.097*** -0.042*** -0.006 1.000
Duality -0.019** 0.109*** -0.013 -0.140*** 1.000
Q -0.057*** 0.043*** -0.005 -0.158*** 0.052*** 1.000
Firm Size 0.204*** -0.015* -0.011 0.251*** -0.125*** -0.270*** 1.000
Firm Age -0.177*** -0.315*** 0.060*** 0.003 -0.165*** 0.179*** 0.170*** 1.000
Lev -0.117*** -0.353*** 0.058*** 0.034*** -0.100*** 0.144*** 0.144*** 0.388*** 1.000
State 0.040*** -0.151*** -0.249*** 0.234*** -0.214*** -0.125*** 0.272*** 0.263*** 0.122*** 1.000
Big4 0.051*** -0.029*** 0.038*** 0.116*** -0.055*** -0.093*** 0.344*** 0.026*** 0.009 0.122*** 1.000
DA 0.020** -0.081*** 0.013 0.019** -0.006 0.044*** -0.001 0.051*** 0.249*** 0.003 -0.011 1.000
Illiq -0.084*** -0.145*** 0.032*** -0.032*** -0.025*** -0.061*** -0.391*** -0.029*** 0.131*** -0.007 -0.082*** 0.103*** 1.000
Turnover 0.070*** 0.308*** -0.016*** -0.078*** 0.128*** 0.001*** -0.102*** -0.359*** -0.214*** -0.193*** -0.069*** -0.053*** -0.307*** 1.000
26
Table 3: Impact of Corporate Governance on Investment-Cash Flow Sensitivity
This table reports the regression of firm’s investment on cash flow, and variables of corporate
governance, including wedge, the state dummy, and duality. All variables are defined in Table 1. In
each cell the regression coefficient and t-statistics in parentheses are reported in the upper and lower
case, respectively. ***, **, and * denote the significance level of 1%, 5%, and 10%, respectively.
Full Sample Subsample: High-Cash Low-Q
(1) (2) (3) (4)
Intercept -0.4310***
(-20.92)
-0.4215***
(-20.06)
-0.4623***
(-18.71)
-0.4357***
(-6.03)
Cash/K 0.0219***
(2.88)
0.0207*
(1.87)
0.1666***
(2.63)
0.0295
(0.19)
Wedge -0.0437***
(-2.37)
-0.0481**
(-2.51)
-0.0452**
(-2.35)
-0.2072***
(-3.71)
State
-0.0034
(-1.04)
-0.0034
(-1.00)
-0.0129
(-1.22)
Duality
0.0085**
(2.04)
0.0409***
(3.26)
Board Size
0.0572***
(3.38)
0.0241
(0.43)
Wedge*Cash/K 0.2738***
(3.79)
0.3105***
(4.20)
0.2807***
(3.75)
0.8216***
(4.93)
State*Cash/K
0.0296**
(2.44)
0.0213
(1.63)
0.0530*
(1.69)
Duality*Cash/K
-0.0616***
(-4.32)
-0.1133***
(-3.39)
Board Size*Cash/K
-0.1491**
(-2.20)
-0.0758
(-0.45)
Q 0.0096***
(8.47)
0.0096***
(8.43)
0.0096***
(8.40)
0.0119***
(0.77)
Firm Size 0.0617***
(28.11)
0.0610***
(27.03)
0.0593***
(25.76)
0.0638***
(11.1)
Firm Age -0.0608***
(-19.01)
-0.0625***
(-18.94)
-0.0627***
(-18.91)
-0.07358***
(-10.03)
Lev -0.0352***
(-7.28)
-0.0354***
(-7.31)
-0.0354***
(-7.33)
-0.0603***
(-4.07)
Industry YES YES YES YES
Year YES YES YES YES
28
Table 4: Impact of Information Asymmetry on Investment-Cash Flow Sensitivity
This table reports the regression of firm’s investment on cash flow, and variables of information
asymmetry, including the big-4 dummy, discretionary accruals, illiquidity, and turnover. All variables
are defined in Table 1. In each cell the regression coefficient and t-statistics in parentheses are reported
in the upper and lower case, respectively. ***, **, and * denote the significance level of 1%, 5%, and
10%, respectively.
Full Sample Subsample: Low-Cash and High Q
(1) (2) (3) (4)
Intercept -0.4610***
(-21.27)
-0.5010***
(-21.02)
-0.5263***
(-21.30)
-0.3780***
(-8.85)
Cash/K 0.0365***
(5.49)
0.0534***
(6.86)
0.0517***
(6.47)
0.1401**
(2.34)
Big4 -0.0195***
(-3.03)
-0.0187***
(-2.92)
-0.0267
(-1.30)
DA 0.0055***
(3.25)
0.0055***
(3.24)
-0.0002
(-0.06)
Illiq
1.3395***
(4.27)
1.3062***
(4.17)
1.2145**
(2.50)
Turnover 0.0343***
(5.90)
0.0332***
(5.73)
0.0230
(1.19)
Big4*Cash/K -0.0151
(-0.59)
-0.0211
(-0.82)
0.0433
(0.20)
DA*Cash/K 0.0192***
(5.66)
0.0186***
(5.51)
0.0503
(1.58)
Illiq*Cash/K 1.4140***
(4.54)
1.4496***
(4.67)
-0.2413
(-0.17)
Turnover*Cash/K -0.0596***
(-5.48)
-0.0574***
(-5.28)
0.2208
(1.21)
Q 0.0096***
(8.48)
0.0105***
(9.12)
0.0105***
(9.12)
0.0078***
(4.54)
Firm Size 0.0651***
(27.42)
0.0672***
(27.17)
0.0706***
(27.22)
0.0544***
(12.45)
Firm Age -0.0608***
(-18.65)
-0.0580***
(-17.00)
-0.0580
(-17.03)
-0.0716***
(-10.64)
Lev -0.0439***
(-8.87)
-0.0394***
(-8.04)
-0.0478
(-9.55)
-0.0501***
(-6.77)
State 0.0022
(1.01)
0.0017
(0.78)
0.0021
(0.98)
0.0070**
(1.97)
30
Table 5: Investment-Cash Flow Sensitivity- Before and After Share Reform
This table reports the investment-cash flow regression results for firms involving share reform. All
variables are defined in Table 1. ***, **, and * denote the significance level of 1%, 5%, and 10%,
respectively.
Before Share Reform After Share Reform Full Sample
(1) (3) (4)
Intercept -0.7367***
(-10.56)
-0.5362***
(-15.20)
-0.5831***
(-18.67)
Cash/K 0.4640***
(2.71)
0.2026**
(2.71)
0.3374***
(4.13)
Wedge -0.0343
(-0.76)
-0.0224
(-0.87)
-0.0316
(-1.41)
State -0.0045
(-0.56)
0.0115**
(2.52)
0.0100**
(2.51)
Duality 0.0150
(1.40)
0.0032
(0.56)
0.0010
(0.20)
Board Size 0.1260***
(3.52)
0.0179
(0.61)
0.0532***
(2.77)
Wedge*Cash/K 0.1152
(0.57)
0.2240**
(2.01)
0.2199**
(2.25)
State*Cash/K -0.0011
(-0.03)
-0.0471**
(-2.52)
-0.0427**
(-2.55)
Duality*Cash/K -0.0344
(-0.71)
-0.0396*
(-1.65)
-0.0388*
(-1.80)
Board Size*Cash/K -0.4789***
(-2.72)
-0.0645
(-0.65)
-0.2336***
(-2.70)
Q 0.0029
(0.75)
0.0104***
(7.27)
0.0089***
(6.86)
Firm Size 0.0830***
(12.21)
0.0688***
(21.55)
0.0708***
(24.28)
Firm Age -0.1009***
(-12.5)
-0.0753***
(-10.24)
-0.0873***
(-16.71)
Lev 0.0184***
(4.05)
0.0191***
(7.51)
0.0178***
(8.04)
Industry YES YES YES
Year YES YES YES
Adjusted R2 0.1608 0.1594 0.1552