Legal Protection, Equity Dependence and Corporate Investment: Evidence from Around the World YUANTO KUSNADI City University of Hong Kong SHERIDAN TITMAN University of Texas at Austin & NBER K.C. JOHN WEI HKUST February 2009

2 Introduction Investment equation: Q-theory: corporate investment is positively associated to stock prices (Tobin’s Q). Two explanations: Stock prices reflect investment opportunities. The equity-financing channel.

3 Introduction Learning hypothesis: Stock prices contain may contain private information that managers do not know (eg: Dow and Gorton (1997); Subrahmanyam and Titman (1999)). Financing markets are not a sideshow (Chen et al. (2007)). Behavioral finance literature: Stock markets may not be efficient, ie: there exists non- fundamental component in stock prices (mispricing). Equity-financing channel argument.

4 Introduction Motivation: Very little is known regarding the relationship between corporate investment and the stock market outside the U.S. Few studies examine if cross-country differences in institutional characteristics (as a measure of private information) could determine firm-level corporate investment decisions. Objectives and Contributions: Examine the role of legal protection and equity dependence on the sensitivity of corporate investment to stock prices. No previous study has empirically examined these issues simultaneously.

5 Summary of Results Positive relationship between legal protection of investors and investment-stock price sensitivity. Investment-stock price sensitivity also increases monotonically with the degree of equity-dependence. Role of the equity-financing channel The positive association between legal protection and investment-stock price sensitivity is more pronounced for equity-dependent firms. Therefore, both legal protection and equity dependence influence managers’ corporate investment decisions with respect to changes in stock prices.

6 Related Literatures Corporate investment and stock prices Empirical evidence is mixed: Morck et al. (1990) and Blanchard et al. (1993): stock market is a sideshow! Chirinko and Schaller (2001); Baker et al. (2003); Chen et al. (2007): the stock market matters and affects real investment! Chen et al. (2007) Learning channel argument Stein (1996); Baker et al. (2003) Equity-financing channel argument

7 Related Literatures The role of legal protection: Rights prescribed by regulations and laws + effectiveness of enforcement. LLSV (1997, 1998, 2002): effect of legal protection LLSV (2006): effect of securities laws Chen et al. (2005) & Hail and Leuz (2006): relationship with cost of capital. Wurgler (2000): capital market development promotes efficient allocation of capital.

8 Hypothesis 1 The role of legal protection (cont’d): Agency problems  inefficient corporate investment decisions. Mitigated by strong legal protection. For those firms in countries with strong legal protection: stock prices should reflect more innovation in investment opportunities  more efficient allocation of capital. Baker et al. (2003): an increase in the investment-stock price sensitivity  greater efficiency in capital allocation. Hypothesis 1: Firms in countries with strong legal protection have corporate investment that is more sensitive to their stock prices.

9 Hypothesis 2 Baker et al. (2003): Extends the model in Stein (1996) and derive implications on the role of the equity-financing channel on corporate investment. Effect of stock market irrationality on investment decisions of nonequity-dependent and equity dependent firms. Hypothesis 2: Equity-dependent firms have corporate investment that is more sensitive to their stock prices than do nonequity-dependent firms.

10 Related Literatures Baker et al. (2003) (cont’d): Agency problems further increases the incentives of managers of nonequity-dependent firms to smooth investments. Almeida and Wolfenzon (2005): As the level of legal protection increases, managers have to switch to more productive projects. The presence of financial constraints further ensure managers’ commitment in the termination of average projects. Hypothesis 3: The effect of legal protection on the sensitivity of corporate investment to stock prices is more pronounced for equity dependent firms than for nonequity-dependent firms.

11 Data Legal protection measures: Anti-directors rights, private, and public enforcement (LLS, 2006). Firm-level financial data (Worldscope and Datastream): Capital expenditures, cash-flow, Tobin’s Q, and variables required to construct the KZ-Index. Exclude financial firms; firms with book equity < US$10 million; firms with missing firm-year observations. Use modified KZ-Index as in Baker et al. (2003) as measure of equity- dependence: Also use the “adjusted” KZ-Index by resetting the weights of the components of the index for each country. Unbalanced panel data consisting of 110,082 firm-year observations for 17,009 firms in 43 countries, from

12 Table 3 – Role of Legal Protection

13 Table 4 – Sensitivity Analysis

14 Table 5 – Role of Equity Dependence

15 Table 7 – Role of Legal Protection and Equity-Dependence

16 Conclusion Legal protection and the equity-financing channel matter for the sensitivity of corporate investment to stock prices in an international setting. Important implications for regulators and individual firms: better appreciate the role of legal protection on corporate investment behavior through equity- financing channel. Overall, legal protection and equity dependence interact with each other, with the objective of attaining efficient allocation of capital to investment projects.