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

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). 2

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). 3

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) 4

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 ? 5

Hypothesis Statements Corporate Governance Investment Efficiency Excess Values of Diversified Firms 6

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. 7

Five Dimensions on Governance Mechanisms board characteristics ownership structure CEO compensation audit committee market for corporate control 8

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) board Independence 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 board fraction of the board’s directors hold three of more directorships +/? (?): Ferris Jagannathan, and Pritchard (2003) (-): Fich and Shivdasani (2006) 9

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) 10

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) 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) 11

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 control governance Index (GIM) - (+): Jensen (1988), Scharfstein (1988), Jensen and Ruback (1993), Gompers et al. (2003), Dittmar and Mahrt-Smith (2007) 12

Measuring investment allocations Rajan et al. (2000) 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.

Measuring investment allocations 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

Firm-level measures of investment efficiency IFAIR 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.

Firm-level measures of investment efficiency relative value added by allocation (RVA) absolute value added by allocation (AVA) IFAIR IAIR

Studied Periods year 1996 year 2001 year 2005 9222 7630 533- 2503/ Robust Check 9222 7630 533- 2503/ 6366 Number of available governance / Compustat observations 17

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. 18

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 19

Sample Distributions (2/2) Number of available governance observations (year=2005) Board size 892 Board independence Leadership structure Busy board 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 Market for corporate control 1269 20

Descriptive Statistics Governance 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*** 21

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. 22

Investment Efficiency for Multi-segment Firms Stratified by Governance Mechanisms Allocation (1/2) Panel A : RINV High value of variables Lower value of variables differences 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 -0.0003 0.0007 Blockholder ownership 0.0028 0.0003 -0.0026 0.0054 Institutional ownership 0.0075 0.0014 -0.0083 -0.0013 0.0158*** 0.0027*** 23

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 (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 0.0163*** 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 -0.0135*** -0.0007*** 24

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 25

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. 26

Regression of Investment Efficiency (RINV) on Governance Mechanisms (1/3) Model 1 2 3 4 GM Board size Board independence Leadership structure Busy board Intercept 0.011 -0.027** 0.007 0.004 -0.001 0.001*** -0.011** -0.001*** inverseQ 0.005 0.001 Diversity -0.005 Size Adjusted R2 -0.011 0.020 0.036 F-statistic 0.29 4.37*** 1.25 3.52** N 263 27

Regression of Investment Efficiency (RINV) on Governance Mechanisms (2/3) Model 5 6 7 8 GM Insider ownership Blockholder ownership Institutional ownership (Outside) director ownership Intercept -0.008 -0.012 -0.019*** -0.005 -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 Adjusted R2 -0.004 0.043 0.04 F-statistic 0.71 0.93 6.61*** 7.25*** N 292 283 501 262 28

Regression of Investment Efficiency (RINV) on Governance Mechanisms (3/3) Model 9 10 11 12 13 GM CEO 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* 0.022*** 0.001 0.014*** 0.002*** -0.002*** inverseQ 0.016 0.002 0.004 0.032* Diversity -0.014 -0.001 Size 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 303 120 260 332 29

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 ? 30

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. 31

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 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 32

Panel B : High GOV samples High Q Low Q differences 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 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 33

Panel C : Low GOV samples High Q Low Q differences 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 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 0.0643 -0.0017 0.0022 0.0017*** Number of segments 390 228 Number of firms 177 119 34

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. 35

Excess Value, Efficiency of Investments, & Corporate Governance Excess Values Model High 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 Herfindahl 0.153 0.122 0.316 0.410 Leverage 0.017 0.074 0.239 0.254 Size 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 36

All have the similar results for regression and descriptive statistics Robust Check 1 RINV RVA AVA All have the similar results for regression and descriptive statistics investment efficiencies - RINV: relative investment ratio RVA: relative value added by allocation AVA: absolute value added by allocation 37

All have the similar results for regression and descriptive statistics Robust Check 2 2005 Year Year 2001 Year 1996 All have the similar results for regression and descriptive statistics 38

Excess Values of Diversified Firms Conclusions (1/2) Corporate Governance Investment Efficiency Excess Values of Diversified Firms + + 39

Conclusions (2/2) 40 Better investment efficiencies higher board independence less busy board higher institutional ownership higher outside director ownership higher CEO equity-based pay better audit quality better shareholder’s protection 40

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. 41

Comments Welcome. 42