1. Cost of Equity, Control Divergence, and Institutions Teresa Chu, University of Macau In-Mu Haw, Texas Christian University Lee-Seok Hwang, Seoul National University Woody Wu, Chinese University of Hong Kong

2. 2 Cost of Equity, Control Divergence, and Institutions 1.Introduction 2.Literature Review & Hypotheses Development 3.Research Design & Sample 4.Empirical Results & Interpretations 5.Conclusions

3. 3 Introduction Research Questions: Whether the separation of ownership and control of the ultimate owner is systematically related to the firm’s cost of equity capital? Whether the investor protections play a corporate governance role in constraining the risk of expropriation of minority shareholders thereby reduce the increase in the cost of equity capital as induced by the ultimate ownership structure?

4. 4 Literature Review - Cost of equity capital models Cost of capital is the expected return of investors who supplied financial capital to firms Market information models: Modigliani and Miller (1958), Sharpe (1964), Fama and French (1993 & 1995), etc. Accounting information models: Ohlson (1995), Gebhardt et al. (2001), Claus and Thomas (2001), Easton (2004), Ohlson and Juettner (2005), etc. Gode and Mohanram (2001 & 2003), Botosan and Plumlee (2005), Easton and Monahan (2005) and Guay et al. (2005) examine different cost of equity models but find confounding results

5. 5 Literature Review - Cost of equity & corporate governance Corporate governance emerged from concern over the principal-agent problem in corporations Insider trading enforcement has negative and significant association with equity cost (Bhattacharya and Daouk [2002]) Firms with high quality accounting earnings can enjoy significantly lower cost of equity (Francis et al. [2004]) Both theoretical and empirical studies generally support a negative relation between disclosure levels and cost of equity (Diamond and Verrecchia [1991], Easley O’Hara [2004], Botosan [1997], Botosan and Plumlee [2002], Hail [2002], Chen et al. [2004], Hail and Leuz [2006a], etc.)

6. 6 Literature Review - Ultimate ownership Ultimate owner is the shareholder who has determining voting rights and not controlled by anyone else Except for large firms in richest common law countries, firms are typically controlled by families or government AND ultimate owners generally possess control rights in excess of ownership rights through group structure and management participation (La Porta et al. [1999]) Other studies find similar phenomenon in East Asia (Claessens et al. [2000]), Western Europe (Faccio and Lang [2002]), Canada (Attig et al. [2002]), Sweden (Cronqvist and Nilsson [2003]) and emerging economies (Lins [2003])

7. 7 Literature Review - Ultimate ownership & expropriation of minority shareholders Concentrated ownership may lead to opportunistic incentives of ultimate owners to hold up minority investors (Shleifer and Vishny [1997]) Recent evidence of expropriation:  Less informative accounting earnings (Fan and Wong [2002])  Income management incentives (Haw et al. [2004])  Higher dividend rates (Faccio et al. [2001] and Leung [2004])  Firm value discounts (Claessens et al. [2002], Lins [2003], Lemmon & Lins [2003])  Lower stock returns (Baek, et al. [2004])  Higher asymmetric information costs (Attig et al. [2002] & [2006])  Higher agency costs (Cronqvist & Nilsson [2003])  Higher external auditing costs (Fan and Wong [2005])

8. 8 Outside United States, concentrated ownership and ownership-control divergence is prevalent (La Porta et al. [1999], Claessens et al. [2000], Attig et al. [2002], Faccio and Lang [2002], Lins [2003], Cronqvist and Nilsson [2003], etc.) Ultimate owners have both incentives and abilities of expropriation (Shleifer and Vishny [1997]) Shift agency conflicts to between controlling owners and minority investors Hypothesis One

9. 9 No ideal ownership structure and entrepreneurs can set up a particular organizational structure to achieve different objectives To provide private enforcement of property rights and confront poor judicial system (La Porta et al. [1999]) To preserve proprietary information and optimize decision making (Christie et al. [2003]) Conjecture those controlling owners who obtain effective control but maintain low equity investment have incentives to expropriate Hypothesis One - continued

10. 10 Firm ownership structure is observable and shareholders can price-protect themselves if they expect potential divergent actions by controlling owners Evidence shows that shareholders capitalize potential agency costs into stock price (Claessens et al. [2002], Lins [2003] and Lemmon and Lins [2003]) Ownership-control divergence increases bid-ask spread hence higher asymmetric information costs and agency costs (Attig et al. [2002]) Big 5 auditors charge fee premium to clients with controlling owners (Fan and Wong [2005]) Detrimental effect caused by ownership-control divergence increase potential costs and should ultimately translate to higher external capital cost Hypothesis One - continued

11. 11 Hypothesis One - continued H1: Positive relationship exists between the firm’s cost of equity capital and the level of ownership-control divergence of the ultimate owner, after controlling for traditional risk factors, industry factors and country factors.

12. 12 Alternative explanations: Firms engage in group building precisely because they suffer from capital market imperfection  Group-affiliated firms can benefit from risk sharing, internal capital transfer, income smoothing and liquidity smoothing (Khana and Yahef [2005] and Claessens et al. [2006])  Internal market hypothesis is efficient in Japanese keiretsu (Hoshi et al. [1991]) Agency problem arises from reasons unrelated to firm’s cost of equity  Concentrated ownership alleviates free-riding problem as in dispersed shareholding (Grossman and Hart [1980] and Shleifer and Vishny [1986])  Agency problem is simply a side effect of monitoring Hypothesis One - continued

13. 13 Literature Review - Role of investor protections Investor protection is potentially useful corporate governance mechanism as it reduces power and incentives of controlling owners and makes expropriation less cost effective (La Porta et al. [2000]) Some recent evidence:  Better shareholder protection is associated with higher valuation of corporate assets (La Porta et al. [2002])  Foreign firms that cross-list in U.S. have significantly higher firm valuations (Doidge et al. [2004])  Firms in countries with strong and well-enforced outsider rights engage in less earnings management (Leuz et al. [2003])  Extra-legal investor protection outperforms legal investor protection in constraining earnings management (Haw et al. [2004])  Both legal and extra-legal mechanisms can curb private benefits of control (Dyck and Zingales [2004])

14. 14 Good investor protection is expected to be able to constrain the higher equity cost as induced by the ultimate ownership structure Evidence shows that legal protection is directly related to cost of equity  Insider trading enforcement (Bhattachrya & Daouk [2002]), high quality accounting standards (Francis et al. [2004]), extensive securities regulation and strong enforcement mechanism (Hail and Leuz [2006a]) are negatively associated with cost of equity  Stronger commitment to stricter corporate governance also have a significant impact on cost of equity (Hail and Leuz [2006b]) Hypothesis Two & Three

15. 15 Legal protection is expected to reduce cost of equity indirectly through less severe agency problem  Less auditing and enforcement costs (Lombardo & Pagano [2000]), decrease information asymmetry and increase stock liquidity (Brockman & Chung [2003]), less earnings management (Leuz et al. [2003] and Haw et al. [2004]) and higher firm valuation (La Porta et al. [2002], Lins [2003] and Doidge et al. [2004]) Extra-legal investor protection can further restrain private benefits of control (Dyck and Zingales [2004] and Haw et al. [2004]) Extra legal investor protection provides auxiliary investor protection or surrogate for legal protection Hypothesis Two & Three - continued

16. 16 H2: The positive relation between the firm’s cost of equity capital and the level of ownership-control divergence of the ultimate owner is less pronounced in high legal investor protection countries Two legal institutional factors: (1) Disclosure requirement index (DISRE) (2) Securities regulation index (SECRE) Hypothesis Two & Three - continued

17. 17 H3: The positive relation between the firm’s cost of equity capital and the level of ownership-control divergence of the ultimate owner is less pronounced in high extra-legal investor protection countries Two extra-legal institutional factors: (1) Product market competition (MKTCOM) (2) Tax compliance (TAXCOM) Hypothesis Two & Three - continued

18. 18 Research Design and Sample 21 countries (9 East Asian plus 12 Western European countries) 1991 to 2003 Both financial and industrial firms Financial data (Worldscope) Analysts forecasts and price (IBES international) Ownership structure (Claessens et al. [2000] and Faccio & Lang [2002]) Legal institutional variables (La Porta et al. [2006]) Extra-legal institutional variables (Dyck & Zingales [2004])

19. 19 Research Design and Sample - continued 4 implied cost of equity models  Claus and Thomas (2001)  Gebhardt et al. (2001)  Ohlson and Juettner-Nauroth (2005)  Easton (2004) Final Sample consists of 8,868 firm-years (or 1,791 individual firms)

20. 20 Research Design and Sample - continued Firm-years Initial sample in WORLDSCOPE with sufficient data to compute SIZE, DB and ROAVAR 79,586 Less: Insufficient data for RETVAR(34,362) Insufficient data for FBIAS(17,189) Insufficient data for r avg (9,680) No ownership data(8,407) 1% of all firm-level attributes (except SIZE), firm-years with inflation rates greater than 25% and less than 5 observations in a country-year (1,080) Final sample8,868

21. 21 Descriptive Statistics- Table 1 Panel A: Distributional Statistics Percentile VariableNMeanStd. Dev.Min.Q1Q2Q3Max. r CT 8,89410.09%4.13%3.49%7.27%9.40%11.96%31.38% r GLS 8,9689.37%4.37%2.28%5.84%9.03%12.17%24.07% r OJ 8,92311.97%4.27%5.01%9.08%11.10%14.02%32.49% r PEG 13,37411.94%5.48%2.92%8.29%10.89%14.49%40.69% r AVG 8,86810.89%3.91%4.37%8.13%10.26%12.83%28.22%

22. 22 Descriptive Statistics- Table 1 Panel B: Pearson Correlation Coefficients Variabler CT r GLS r OJ r PEG r GLS 0.609 * r OJ 0.810 *0.528 * r PEG 0.562 *0.465 *0.865 * r AVG 0.865 *0.758 *0.938 *0.856 * * indicates statistical significance at 1% level (two-tailed)

23. 23 Descriptive Statistics- Table 1 Panel C: Sample Information, Cost of Equity Proxies and Institution Variables by Country CountryFirm-yearsCountry-yearsMean CoverageMean r AVG Standard Deviation Disclosure Requirement Securities Regulation Market Competition Tax Compliance 1Austria1231036.20%11.00%3.36%0.250.185.293.60 2Belgium2051248.42%11.05%3.52%0.420.34-- 3Finland2931230.41%13.23%3.97%0.500.495.263.53 4France7101325.60%11.13%3.56%0.750.585.833.86 5Germany8281349.14%10.62%3.59%0.420.215.913.41 6Hong Kong4731342.06%13.41%4.25%0.920.815.854.56 7Indonesia88825.94%16.42%4.81%0.500.594.422.53 8Italy1661115.27%9.76%3.09%0.670.465.141.77 9Japan1,6381322.26%7.84%2.69%0.750.475.644.41 10Korea (South)70418.95%15.72%4.35%0.750.554.903.29 11Malaysia4111336.34%10.39%3.31%0.920.784.844.34 12Norway1561239.08%12.85%3.68%0.580.434.963.96 13Philippines1101027.74%14.28%4.24%0.830.894.611.83 14Portugal35539.95%10.07%2.78%0.420.554.812.18 15Singapore3391339.38%10.31%4.12%1.000.845.215.05 16Spain2941331.03%10.94%3.12%0.50 5.071.91 17Sweden2981334.34%12.00%3.99%0.580.455.083.39 18Switzerland237123.18%11.19%2.75%0.670.485.224.49 19Taiwan1351015.57%10.43%2.69%0.750.645.563.25 20Thailand69810.81%14.22%4.42%0.920.624.773.41 21UK2,1901345.37%11.64%3.53%0.830.735.744.67 Total/Average8,86823131.24%11.83%3.61%0.660.555.213.47

24. 24 Traditional risk controls  SIZE = Natural log of US$ market capitalization  RETVAR = Standard deviation of monthly returns over last 12 months  DB = Total long-term debt  Total common equity  ROAVAR = Standard deviation of accounting ROA over last 5 years  FBIAS = (Mean forecast EPS 1 - Actual EPS)/Price  INFL = Expected inflation proxied by 1-year ahead realized annual inflation rate Research Design and Sample - continued

25. 25 Descriptive Statistics- Table 2 Panel A: Distributional Statistics Percentile VariableNMeanStd. Dev.Min.Q1Q2Q3Max. INFL8,8681.78%1.88%-3.20%0.60%1.70%2.91%11.88% SIZE8,8686.6351.6271.3595.4686.5067.72312.432 RETVAR8,8680.0980.0470.0290.0650.0880.1180.354 DB8,8680.5360.7800.0000.0760.3090.6797.495 ROAVAR8,8680.0300.0330.0020.0100.0190.0360.241 FBIAS8,8680.0090.041-0.061-0.0050.00040.0100.439 CASH8,86820.93%19.85%0.00%5.00%15.00%31.33%100.00% VOTE8,86825.00%20.42%0.00%10.00%20.00%36.00%100.00% DIV8,8680.1960.2970.000 0.3811.000

26. 26 Descriptive Statistics- Table 2 Panel B: Pearson Correlation Coefficients VariableINFLSIZERETVARDBROAVARFBIASCASHVOTEDIV SIZE-0.108 * RETVAR-0.052 *-0.148 * DB-0.075 *0.134 *0.020 # ROAVAR0.112 *-0.207 *0.187 *-0.062 * FBIAS-0.019 #-0.123 *0.158 *0.063 *0.052 * CASH0.144 *-0.229 *0.013-0.035 *0.038 *0.048 * VOTE0.139 *-0.239 *0.013-0.032 *0.031 *0.053 *0.930 * DIV-0.172 *0.075 *0.0070.050 *-0.097 *0.010-0.400 *-0.135 * r AVG 0.251 *-0.418 *0.200 *0.051 *0.226 *0.271 *0.128 *0.134 *-0.087 * * and # indicate statistical significance at 1% and 10% levels (two-tailed), respectively

27. 27 Empirical Results & Interpretations To test H1:

28. 28 Main Results – Table 3 VariableModel 1Model 2Model 3Model 4 N8,868 13 Intercept?15.711 *16.095 *16.016 *20.588 * VOTE+--0.004-- DIV+-- 0.295 **0.277 * CASH  ---0.013 **-0.008 *-0.007 * INFL+0.208 * -2.251 SIZE  -0.729 *-0.747 *-0.745 *-0.658 * RETVAR+8.028 *8.001 *7.993 *9.857 * DB+0.639 *0.636 *0.634 *0.616 * ROAVAR+3.222 **3.147 **3.218 **4.799 * FBIAS+19.466 *19.482 *19.480 *17.540 * YearIncluded -- Industry & CountryIncluded Adj. R 2 43.60%43.75%43.79%48.82% F-Statistics150.01 *144.70 *144.89 *-- * and ** indicate statistical significance at 1% and 5% levels (two-tailed), respectively

29. 29 Sensitivity Analyses of Main Results – Table 4 r MED r PC r PREM r DP r FF Variable(1)(2)(3)(4)(5) N8,8588,868 7,0836,037 Intercept?15.446 *2.235 *14.325 *4.891 *3.174 * DIV+0.268 #0.129 **0.252 #0.136 #0.278 ** CASH  -0.007 **-0.003 *-0.009 *-0.003 **0.002 INFL+0.200 *0.092 *--0.084 **0.036 SIZE  -0.759 *-0.329 *-0.757 *-0.185 *-0.006 RETVAR+8.359 *3.533 *7.604 *-4.402 *11.676 * DB+0.659 *0.282 *0.627 *-0.0110.261 * ROAVAR+3.233 **1.384 **3.028 **-5.556 *8.925 * FBIAS+19.250 *8.474 *19.439 *-- g Forecasts +/  -- -0.291 *-- Year, Industry & Country Included Adj. R 2 42.69%43.10%37.44%26.09%19.57% F-Statistics138.42 *140.94 *113.88 *55.34 *36.82 * *, ** and # indicate statistical significance at 1%, 5% and 10% levels (two-tailed), respectively

30. 30 Exclude 8 Euro-in countries Exclude UK Firms Exclude Japanese Firms Exclude Asian Firms during 1995 to 1997 Variable(6)(7)(8)(9) N6,2146,6787,2308,224 Intercept?16.148 *17.363 *16.149 *16.566 * DIV+0.438 **0.286 #0.345 #0.295 # CASH  -0.009 **-0.003-0.009 *-0.008 * INFL+0.209 *0.237 *0.209 *0.222 * SIZE  -0.763 *-0.781 *-0.748 *-0.750 * RETVAR+8.557 *6.374 *7.833 *8.394 * DB+0.507 *0.717 *0.660 *0.649 * ROAVAR+2.826 #4.722 **2.913 #3.127 ** FBIAS+21.478 *17.082 *20.444 *18.848 * Year, Industry & CountryIncluded Adj. R 2 47.70%47.13%35.94%41.83% F-Statistics142.64 *127.63 *87.31 *124.17 * *, ** and # indicate statistical significance at 1%, 5% and 10% levels (two-tailed), respectively Sensitivity Analyses of Main Results – Table 4

31. 31 Sensitivity Analyses of Main Results – Table 4 Group Affiliation DiversificationExternal Capital Need Financial Constraint 2-stage Regressions Variable(10)(11)(12)(13)(14) N3,3338,5237,7208,4224,651 Intercept?15.786 *15.774 *16.127 *17.135 *16.204 * DIV+0.377 **0.340 **0.369 **0.324 **2.851 # CASH  0.017 **-0.006 ** -0.004 Additional variable +/  -0.00080.065 *0.000-1.159 *-- INFL+0.355 *0.217 *0.230 *0.218 *0.078 SIZE  -0.833 *-0.760 *-0.741 *-0.717 *-0.732 * RETVAR+5.889 *7.892 *8.061 *7.290 *6.171 * DB+0.725 *0.611 *0.642 *0.608 *0.768 * ROAVAR+5.166 **3.439 **3.162 **1.4413.658 FBIAS+17.038 *19.409 *20.218 *19.684 *15.684 * Year, Industry & Country Included Adj. R 2 56.62%44.10%43.10%44.75%49.34% F-Statistics118.54 *138.21 *120.33 *140.18 *95.33 * *, ** and # indicate statistical significance at 1%, 5% and 10% levels (two-tailed), respectively

32. 32 Foreign ListingBig-5 AuditorCIFAR Variable(15)(16)(17) N8,5188,4881,283 Intercept?16.277 *16.042 *8.290 * DIV+0.378 **0.354 **0.474 # CASH  -0.006 **-0.007 **0.026 * Additional variable +/  0.514 *-0.0610.031 ** INFL+0.218 *0.197 *0.256 * SIZE  -0.797 *-0.732 *-0.000 * RETVAR+7.819 *7.758 *18.329 * DB+0.621 *0.629 *0.533 * ROAVAR+2.975 **3.490 **-0.583 FBIAS+19.403 *19.420 *11.836 ** Year, Industry & CountryIncluded Adj. R 2 44.22%43.76%51.71% F-Statistics138.81 *135.78 *30.85 * *, ** and # indicate statistical significance at 1%, 5% and 10% levels (two-tailed), respectively Sensitivity Analyses of Main Results – Table 4

33. 33 Empirical Results & Interpretations - continued Ownership-control divergence of the ultimate owner has a positive and significant relation with the cost of equity capital Cash-flow rights of the ultimate owner has a negative and significant relation Results are robust to alternative cost of equity proxies, sub-samples, specifications and with/without potentially correlated omitted variables

34. 34 To test H2 and H3, full sample is split into sub- samples using partitioning variables  Sub-sample equals low for countries with less than or equal to the median index values of 49 countries (La Porta et al. [2006]) and 39 countries (Dyck & Zingales [2004])  Run separate regression of the main model for each sub-sample Empirical Results & Interpretations - continued

35. 35 Role of Legal Protection – Table 5 Disclosure RequirementSecurities Regulation VariableLowHighLowHigh N2,3206,5483,9444,924 Intercept?17.526 *15.701 *16.216 *14.971 * DIV+0.559 #0.2340.348 **0.297 CASH  -0.005-0.009 **-0.006-0.008 ** INFL+-0.1650.241 *0.0040.249 * SIZE  -0.792 *-0.744 *-0.745 *-0.751 * RETVAR+7.907 *8.114 *8.193 *7.314 * DB+0.873 *0.542 *0.695 *0.562 * ROAVAR+5.065 #2.4754.3742.539 FBIAS+16.698 *20.359 *15.459 *22.591 * Year, Industry & CountryIncluded Adj. R 2 38.33%45.59%47.36%36.94% F-Statistics41.03 *141.66 *99.53 *74.96 * *, ** and # indicate statistical significance at 1%, 5% and 10% levels (two-tailed), respectively

36. 36 Role of Extra-legal Protection – Table 6 Market CompetitionTax Compliance VariableLowHighLowHigh N1,5317,1321,1967,467 Intercept?19.029 *14.142 *16. 397 *15.550 * DIV+1.071 **0.1960.834 #0.230 CASH  -0.007-0.008 **-0.005-0.008 * INFL+0.1220.226 *0.0480.214 * SIZE  -0.859 *-0.733 *-0.865 *-0.728 * RETVAR+3.792 #8.419 *3.5868.144 * DB+0.543 *0.648 *0.655 *0.628 * ROAVAR+3.1263.160 #9.650 *2.117 FBIAS+22.089 *19.133 *15.666 *20.233 * Year, Industry & CountryIncluded Adj. R 2 42.74%43.10%46.08%43.39% F-Statistics32.73 *143.12 *30.17 *147.76 * *, ** and # indicate statistical significance at 1%, 5% and 10% levels (two-tailed), respectively

37. 37 Empirical Results & Interpretations - continued To further support H2 and H3, introduce the legal and extra-legal institutional variables into the regressions INSTITUTION = (1) DISRE (2) SECRE (3) MKTCOM (4) TAXCOM

38. 38 Role of Legal Protection – Table 7 Disclosure RequirementSecurities Regulation Variable(1)(2) N8,868 Intercept?13.527 *11.779 * DIV+2.454 *1.266 ** DIV  DISRE _-3.931 * DIV  SECRE _-2.359 ** DISRE_0.495 SECRE_3.346 * CASH_-0.0070.027 * CASH  DISRE _0.012 CASH  SECRE _-0.042 * Year & IndustryIncluded Adj. R 2 33.85%34.29% F-Statistics 147.38 *150.28 * * and ** indicate statistical significance at 1% and 5% levels (two-tailed), respectively

39. 39 Role of Extra-legal Protection – Table 8 Market CompetitionTax Compliance Variable(1)(2) N8,663 Intercept?9.225 *14.436 * DIV+13.048 *2.778 ** DIV  MKTCOM _-2.396 * DIV  TAXCOM _-0.757 * MKTCOM_0.903 * TAXCOM_-0.120 CASH_0.034-0.041 * CASH  MKTCOM _-0.006 CASH  TAXCIN _0.011* Year & IndustryIncluded Adj. R 2 33.93%34.01% F-Statistics144.51 *145.03 * * and ** indicate statistical significance at 1% and 5% levels (two-tailed), respectively

40. 40 Empirical Results & Interpretations - continued DIV is always significant and positive in the low legal or extra-legal investor protection samples Magnitude of DIV in low sub-sample is always larger than the one in high sub-sample DIV and the interaction between the legal or extra- legal investor protection are always significant with predicted signs Both analyses support Hypotheses Two and Three in that the positive relation between the ownership- control divergence of the ultimate owner and the cost of equity is less pronounced in strong legal or extra-legal investor protection countries

41. 41 Conclusions Regression results suggest that the ownership- control divergence of the ultimate owner is associated with a significant increase in firm’s cost of equity capital, even after controlling for traditional risk, industry and country factors The increase in cost of equity capital as motivated by the ownership-control divergence of the ultimate owner is significantly limited in countries with extensive prospectus disclosure requirements, effective securities regulation enforcement, intense product market competition and strong disciplinary power of the taxing authority

42. 42 Conclusions - continued Contributions  Direct evidence on relationship between risk of expropriation of minority shareholders and the firm’s cost of equity capital  Isolate cost of capital effects from cash flow effects and supplement prior findings on why firm value declines when control rights exceed ownership rights  Examine sole effect and interaction effect of internal and external forces on the cost of equity  Firm-level variables should contribute more robust results  Empirical evidence on effectiveness of the implied cost of capital models outside U.S.

43. 43 Conclusions - continued Limitations and future research  Measurement errors may exist in the cost of equity proxies  Exclude firms with negative earnings forecasts  Possible selection bias as sample only includes firms with IBES forecasts  Introduce ultimate ownership variables only modestly increase the explanatory power for variations in the cost of equity capital

44. 44 What is Rule of Law? France:Everything is permitted (except what is prohibited) Germany: Everything is prohibited (except what is permitted) Italy:Everything is permitted (including what is prohibited) Russia:Everything is prohibited (including what is permitted) China:?