1. 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

2. 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

3. 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

4. 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

5. 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

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

7. 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

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

9. 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

10. 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

11. 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

12. 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

13. 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.

14. 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

15. 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.

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

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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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
Board independence
0.0081
0.0037
0.0141***
0.0047***
Leadership structure
0.0096
0.0025 ** **
Busy board
0.0090
0.0017
***
***
Insider ownership
0.0007
Blockholder ownership
0.0028
0.0003
0.0054
Institutional ownership
0.0075
0.0014
0.0158***
0.0027*** 23

24. 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
0.0144***
0.0026***
CEO equity-based pay
0.0084
0.0020
0.0130***
0.0027***
CEO ownership
0.0037
0.0006
0.0043
0.0009
Out. Dir. on audit Com.
0.0072
0.0014
0.0163***
0.0017**
No of audit Com. Meetings
0.0093
0.0042
0.0158***
0.0052***
Market for corporate control
0.0002
0.0083
***
*** 24

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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 *
***
Industry adjusted UIR (IAIR)
0.0353
0.0770 **
***
Industry & firm adjusted UIR (IFAIR)
0.0287
0.0667 **
***
Number of segments
1067
665
Number of firms
506
349 32

33. 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
***
***
Industry adjusted UIR (IAIR)
0.0119
0.0804
0.0012
***
***
Industry & firm adjusted UIR (IFAIR)
0.0070
0.0679
0.0003
***
***
Number of segments
677
437
Number of firms
329
230 33

34. 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
0.0057
0.0032***
Industry & firm adjusted UIR (IFAIR)
0.0665
0.0643
0.0022
0.0017***
Number of segments
390
228
Number of firms
177
119 34

35. 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

36. 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

37. 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

38. 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

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

40. 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

41. 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

42. Comments Welcome. 42