Corporate Governance and Capital Allocations of Diversified firms

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

22

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).

33

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).

44

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)

55

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 ?

66

Hypothesis Statements

77

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.

88

Five Dimensions on Governance Mechanisms

99

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)

boardIndependence

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 boardfraction of the board’s directors hold three of more directorships

+/? (?): Ferris Jagannathan, and Pritchard (2003) (-): Fich and Shivdasani (2006)

1010


Internal Governance

B. ownership structure


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)

1111


Internal Governance

C. CEO compensation


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)

CEO 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)

1212


Internal Governance

D. audit committee


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

controlgovernance Index (GIM) -

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

13

Measuring investment allocations

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.=

j

j

S

I

ssj

j

j )S

I(

S

I

Rajan et al. (2000)

14

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

n

1j

ssj

j

jj

ssj

j

j ))S

I(

S

I(w)

S

I(

S

I

jw

Measuring investment allocations

15

Firm-level measures of investment efficiency

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.

TS

SI

S

Iw

SI

S

IS

SI

S

Iw

SI

S

IS ss

jj

jn

j jssj

n

knjj

jj

ssj

j

jn

j jssj

k

jj

jj )))(()(()))(()((

1111

ssjS

I )(

IFAIR

16

relative value added by allocation (RVA)

absolute value added by allocation (AVA)

TS

S

I

S

IqS ss

j

n

jj

jjj ))()(1(

1

TS

SI

S

Iw

SI

S

IqqS ss

jj

jn

j jssj

n

jj

jjj )))(()()((

11

IFAIR

IAIR

Firm-level measures of investment efficiency

1717

Studied Periods

Robust Check

Number of available governance / Compustat observations

1818

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.

1919

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

2020

Number of available governance observations (year=2005)

Board size 892

Board independence 892

Leadership structure 892

Busy board 892

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 881

Market for corporate control 1269

Sample Distributions (2/2)

2121

Descriptive StatisticsGovernance 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*** 1.00***

2222

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.

2323

Investment Efficiency for Multi-segment Firms Stratified by Governance Mechanisms Allocation (1/2)

Panel A : RINVHigh value of

variablesLower value of

variables differences

mean median mean median 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 0.0006 -0.0003 0.0007 0.0007 -0.0001 -0.0010

Blockholder ownership 0.0028 0.0003 -0.0026 0.0003 0.0054 0.0000

Institutional ownership 0.0075 0.0014 -0.0083 -0.0013 0.0158*** 0.0027***

2424

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


(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 -0.0003 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 0.0009-0.0135***

-0.0007***

2525

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

2626






2727

Model 1 2 3 4

GM Board sizeBoard

independenceLeadership structure

Busy board

Intercept 0.011 -0.027** 0.007 0.004

GM -0.001 0.001*** -0.011** -0.001***

inverseQ 0.005 0.001 0.005 0.001

Diversity -0.005 0.005 0.001 -0.005

Size 0.001 -0.001 0.001 0.001

Adjusted R2 -0.011 0.020 0.004 0.036

F-statistic 0.29 4.37*** 1.25 3.52**

N 263 263 263 263

Regression of Investment Efficiency (RINV)on Governance Mechanisms (1/3)

2828


Model 5 6 7 8

GMInsider

ownershipBlockholder ownership

Institutional ownership

(Outside) director

ownership

Intercept -0.008 -0.012 -0.019*** -0.005

GM -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 0.001 0.001 0.001 0.001

Adjusted R2 -0.004 -0.001 0.043 0.04

F-statistic 0.71 0.93 6.61*** 7.25***

N 292 283 501 262

2929


Model 9 10 11 12 13

GMCEO 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*

GM 0.022*** 0.001 0.014*** 0.002*** -0.002***

inverseQ 0.016 0.001 0.002 0.004 0.032*

Diversity 0.001 -0.014 -0.001 0.002 -0.010

Size 0.001 -0.001 -0.001 -0.001 0.001

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 303 120 260 260 332

3030

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 ?

3131






3232

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


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

3333


Panel B : High GOV samples



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***



3434


Panel C : Low GOV samples



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 0.0000 0.0643 -0.0017 0.0022 0.0017***



3535






3636

Excess Value, Efficiency of Investments, & Corporate Governance

Excess Values

ModelHigh 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 0.675

Herfindahl 0.153 0.122 0.316 0.410

Leverage 0.017 0.074 0.239 0.254

Size 0.002 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

3737

Robust Check 1

investment efficiencies -

RINV: relative investment ratio

RVA: relative value added by allocation

AVA: absolute value added by allocation

3838

Robust Check 2

3939

Conclusions (1/2)

+

+

4040

Conclusions (2/2)

4141

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.

4242

Comments Welcome.

Documents

Corporate Governance and Capital Allocations of Diversified firms