Ebook Investor Protection, Ownership, And Investment
In both theoretical and empirical research on investment, asset market signals form the basis of many forward-looking models of investment decisions by value maximizing firms. In practice, however, the usefulness of asset markets both as sources of external financing and as sources of signals about investment opportunities and the cost of external financing depends importantly on the legal system for financial contracting in those asset markets. In many analyses of investment decisions, costs of using asset markets measured by investor protection or the efficiency of the legal system are ignored.
In this paper, we bring together these branches of research on asset markets and investment with the idea that legal systems for investor protection influence significantly whether costs of external financing for investment can be reasonably inferred from asset market information. We emphasize relationships among legal systems for investor protection, concentration of inside ownership of firms, and the sensitivity of firm investment to proxies for internal net worth.
The first premise of our paper is that firms operating in countries with strong investor protection for minority shareholders, ceteris paribus, should find it easier to sell equity shares to anonymous shareholders, and should therefore have lower levels of inside ownership. That is, strong investor protection should lower the marginal cost of equity because it reduces firms’ reliance on the scarce supply of what Gorton and Kahl (1999) call “agency-cost-free” capital, namely, capital concentrated in the hands of rich investors. Our second premise is that equity is complementary to debt in the firm’s capital structure, so that in equilibrium, a lower marginal cost of equity implies a lower marginal cost of debt. This implies that the marginal cost of debt financing which is overwhelmingly the marginal source of external funds for most firms should be lower in countries with strong legal protection for minority shareholders.
We exploit the conjectured relationships among investor protections, shareholder concentration and the marginal cost of debt financing to estimate Euler equations for investment in which the marginal cost of capital is assumed to vary with the firm’s leverage ratio. Consistent with the predictions of our theoretical arguments, firms in countries with weak legal protection for minority shareholders have more highly concentrated shareholdings, and the cost of capital implied by their investment behavior displays more sensitivity to changes in the leverage ratio. From this evidence we conclude that countries with weak legal protection of minority equity investors are likely to have corporate financial structures more exposed to shocks to interest rates or firm net worth. These cross-country differences are also related to earlier analyses of connections between financial development and economic growth and of cross-country variation in output sensitivity to monetary policy (see, e.g, Cecchetti, 1999).
Much of the recent resurgence of interest in links between financial structure and economic growth reflects a growing understanding of the links between finance and corporate governance. The finding of a positive cross-country relationship between financial development and economic growth by King and Levine (1993) stimulated attempts to assess causality (see, e.g., Levine and Zervos, 1998; Demurguc-Kunt and Maksimovic, 1998; and Beck, Levine, and Loyaza, 2000). Studies using firm-level data often focus on consequences of capital-market imperfections for the cost of external financing and investment (see, e.g., the review of studies in Hubbard, 1998).
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