A Revealed Preference Approach to Understanding Corporate Governance Problems: Evidence From Canada

Abstract

Empire-building by managers implies that they use a lower effective discount rate in making investment decisions. We use actual investment decisions to measure the gap between the manager's effective discount rate and the market rate. Our empirical work is based on panel data for 193 Canadian firms. Distinctive institutional features, such as interrelated groups of Canadian firms and concentrated share ownership, allow us to quantify the sensitivity of effective discount rates and governance problems to these institutional control mechanisms.For the firms most likely to be affected by the agency problems highlighted by Jensen (1986), estimated discount rates are 350-400 basis points less than the market rate, supporting the Free Cash Flow view that unresolved corporate governance problems distort firm behavior. Firms in our sample that face Free Cash Flow problems have a stock of fixed capital approximately 7% to 22% higher than would prevail under value maximizing behavior.

Panel Cointegration Estimates of the Effect of Interest Rates, Capital Goods Prices, and Taxes on the Capital Stock

“…This could mean that the covariance between ω and is positive. In this case, k would move more for r 12 Direct estimates of ω by Whited (1992), Ng and Schaller (1996), and Chirinko and Schaller (2004), however, suggest that it may be substantial for some firms -on the order of several hundred basis points.…”

“…To see the intuition for this, consider an empire building manager whose utility function puts some weight on the size of his firm and some weight on the firm's profit. Chirinko and Schaller (2004) have shown that such a manager will use a lower discount rate in evaluating investment projects. Specifically, such a manager will set the marginal product of capital (in the absence of taxes, which we ignore for simplicity) as follows.…”

“…The model in Chirinko and Schaller (2004) shows that firms require some degree of market power in order to give reign to corporate governance problems (i.e., to have 14 To the best of our knowledge, the only direct estimates of φ are provided by Chirinko and Schaller (2004), whose estimate is in the range of 300 to 400 basis points. 15 Specifically, we classify firms as having poor investment opportunities if Tobin's Q is below the median for their industry.…”

Managerial Private Benefits and Overinvestment

“…Research demonstrates that enhanced monitoring by large shareholders decreases the overinvestment of free cash flows by management (Chirinko and Schaller 2004;Richardson 2006). In terms of ownership concentration, Garvey (1992) suggests that large shareholders are not effective in resolving the free cash flow problem.…”

“…According to Jensen (1986), managers increase the resources under their direct control through overinvestment, gaining more power, higher compensation, and a higher level of self-accomplishment. The free cash flow hypothesis established by Jensen predicts a positive correlation between cash flow and investment and has been supported by empirical evidence from different areas around the world: Chirinko and Schaller (2004) examine firms in Canada; Degryse and de Jong (2006) examine firms in the Netherlands; Pindado and de la Torre (2009) examine firms in Spain; Richardson (2006) examines firms in the United States; and Wei and Zhang (2008) examine samples of eight emerging markets in Asia before the Asian financial crisis. According to agency theory, self-interested managers seeking to increase their power will attain higher utility when running larger firms (Stein 2003).…”