MF

36,3
174
Managerial Finance
Vol. 36 No. 3, 2010
pp. 174-200
#Emerald Group Publishing Limited
0307-4358
DOI 10.1108/03074351011019537
Corporate governance and
investment: domestic and foreign
firms in Greece
Elias Dedoussis
Technological Education Institute of Piraeus, Egaleo, Greece, and
Afroditi Papadaki
Department of Accounting and Finance, Athens University of Economics and
Business, Athens, Greece
Abstract
Purpose The purpose of this paper is to test the hypothesis that the nationality of ownership
affects investment through its interaction with return expectations and cash flow and to answer the
question whether this is due to asymmetric information or managerial discretion problems.
Design/methodology/approach Asymmetric information and managerial discretion hypothesis
are being tested in a fully extended model, which provides for a variety of effects from the
explanatory variables. The paper also uses firm and industry variables to account for the investment
opportunities or marginal q instead of using the average Q. Using industrial variables instead of
stock market data enables the possibility to extend the sample to cover a more representative sample
of firms and especially a group of firms where financial constraints are expected to be more profound.
Another aspect of the paper is that the ownership variable varies with the nationality of the
shareholders of the firm and not with the shareholdings of the managers. This means that the paper
restricts its search in two sub-samples, those of domestic firms and of foreign (multinational) ones.
Findings In total, 2,700 domestic and foreign (multinational) manufacturing firms located in
Greece in the 1992-1997 period were examined, providing consistent evidence supporting the
asymmetric information hypothesis against the managerial discretion hypothesis. These results also
support the significance of ownership effects, at least with respect to the national origin of the firms
shareholders.
Originality/value This paper provides evidence that the nationality of ownership affects the
investment behavior and is related with the specific information problems of the firms.
Keywords Corporate governance, Multinational companies, Investments, Greece
Paper type Research paper
1. Introduction
The analysis of investment decisions of the firms is important in the applied research
in many fields of economics not only for the theoretical interesting in the mechanism
formation of these decisions but mainly for the policy implications of these
mechanisms.
The early research in the field was heavily affected by the seminal work of
Modigliani and Miller (1958), who demonstrated that, in perfect capital markets, financial
structure do not affect the market value of the firm. So the various schemes (debt, equity
issue, internal cash flow) used to finance the investment decisions are completely
irrelevant to the market value of the firm leading to what is known hereafter as capital
structure irrelevance. This theorem provides a strong theoretical support to the standard
neoclassical model of investment in which financial factors are totally absent from the
determinants of the optimal investment decisions. This result is also maintained in the
q-theory approach (Tobin, 1969) and finally to the marginal q model of Hayashi (1982).
In these models the investment decisions of the firms are solely explained by the future
profitability of the additional investment known also as marginal q which expresses
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/0307-4358.htm
Corporate
governance
and investment
175
the investment opportunities. The marginal q equals the present discounted value of
profits from new fixed capital investment. The net worth of the firm possibly expressed
by its cash flow has no role in this framework. Furthermore, the availability of funds or
liquidity constraints is irrelevant with the investment decisions of the firm. So the two
cornerstones of the neoclassical model of investment are the marginal q as the exact
measure of investment opportunities and the irrelevance of the net worth of the firm.
However, during the last decades, many researchers in various fields of economic
research have incorporated in their models of investment liquidity or financing
constraints reflecting the fact that the investment decisions of the firms are serious
affected by factors other than those that are predicted in the standard neoclassical
model of investment. These factors are related with the information problems that may
arise when the firm raises the necessary funds from the capital market and the
availability of internal funds.
The critic against the neoclassical model started from the standard assumption of
the representative firm with the meaning that the same empirical specification is in
force for all firms in the market. The first attempt to challenge this assumption must be
attributed to Fazzari et al. (1988) hereafter FHP. The cornerstone in their critic on the
standard neoclassical model of investment is the recent in their times developments in
the theory of corporate finance.
At the beginning of this search FHP used divided payout ratio with the underling
argument that firms with high payouts are more probable to have sufficient internal
funds. Using this assumption firms with low divided payout ratio are considered as
financially constrained where the others do not face the same problem. FHP try to test
whether the same determinants of investment hold for any group of firms. The division
of their sample is based on the dividend policy pursued by the firms. The justification
for this division is that if there is a difference between the cost of external and internal
finance and there are good investment opportunities then there must be low divided
payments and the sensitivity of investment to cash flow (as a measure of net worth)
must be higher in the low-dividend firms than in the case of firms with large divided
payments. If this happens then the effects of net worth can play a role in the
determination of investment decisions.
However, net worth can affect the investment decisions if there exists a gap between
external and internal financing. This gap can be the result of information problems, i.e.
problems associated with the inability of the firm to communicate credibly its own
characteristics (as assets value, investment opportunities, etc.) to the outside investors.
By applying their ideas to the database of value line for manufacturing firms (a
database that after this study is the base of all relevant empirical research in the USA)
they found that financial effects are important for all firms but the sensitivity of
investment to cash flow was greater for firms that pay low dividends. This sensitivity
was even greater for the youngest of this category of firms.
After this work the empirical and theoretical research in the field used many other
criteria to extract the information problems faced in the investment process of the firm.
For example, Kadapakkam et al. (1998), Harhoff (1996) and Vogt (1994) used as
separating criterion the size of the firm. Others as Hoshi et al. (1991) and Schaller (1993)
used firm age. Hoshi et al. (1991) used also participation in large business groups, while
Whited (1992) used financial leverage. In all these studies when the categorization
resulted in significant differences in investment-cash flow sensitivities than the
criterion used to conduct the categorization has been thought to be related with
information problems and finally as evidence for financial constraints.
MF
36,3
176
However, this method of detecting financial constraints is not widely accepted. The
first criticism against this method of categorization was expressed by Kaplan and
Zingales (1997) who argue that when they examined the sample of FHP, in respect with
the sub-sample of low-dividend firms in greater detail they do not find evidence in
support of the financial constraints hypothesis.
They find that firms that appear less financially constrained exhibit significantly
greater investment-cash flow sensitivity than firms that appear more financially
constrained. So according to them these results indicate that a highest sensitivity
cannot be interpreted as evidence that a firm is more financially constrained.
According to Kaplan and Zingales (1995, p. 30), one possible explanation for the high
investment -cash flow sensitivities is that . . . managers are choosing to rely primarily
on internal cash flowto invest despite the availability of additional lowcost funds.
Although FHP in their reply to Kaplan and Zingales, criticize their categorization of
their initial low-dividend payments firms sub-sample as subjective because it was
based on managers statements they agree that further research is needed to identify
the sources of high investment-cash flowsensitivities.
This controversy leads to the formulation and testing of two basic hypotheses. The
first hypothesis relates to the asymmetric information aspect of the information
problem and the second to the managerial discretion one. These hypotheses are
stemmed from the financial economics literature and namely from Jensens (1986) free
cash flow theory and Myers and Majlufs (1984) contribution on information
asymmetries, corporate finance and investment decisions.
Informational asymmetries lead to under-investment caused by increases in the cost
of external funds due to a premium. Managerial discretion may lead to over-investment
caused by the well-known preference of managers for large size. Ownership may affect
managerial discretion by improving information and eliminating the conflict of interests
between owners and managers. The free cash flow problem is thus eliminated.
The second basic critic of the neoclassical model of investment is based on the use of
the marginal q as a measure of the investment opportunities. The estimation problems
related with marginal q lead many researchers from the beginning to use average Q
(which equals the market value of firms assets to their replacement value) as a proxy
frommarginal q.
However, if the assumptions of the model do not hold then the average q is a poor
proxy for marginal q. This could happen if there is imperfect competition in the market
and if there is close interrelation among the firmand investment decisions.
If there is imperfect competition in market then in the model of Hayashi (1982) the
marginal profitability of capital does not equals the ratio of profits to capital but we
need to add a measure of demand elasticity times the sales to capital ratio. If this
happens one possible solution is to include in the estimated relation the sales to capital
ratio. Its coefficient expresses a measure of demand elasticity, which is directly
associated with market power.
By adding this variable in the investment cash flow relation with a coefficient that is
equal to the product of two parameters (one expressing the cost of adjustment and the
other the inverse of demand elasticity) we can take into account the distortion caused
by incomplete markets.
Another solution expressed by Gilchrist and Himmelberg (1998) is to use an
alternative measure instead of the average q, which can be extracted from the static
neoclassical model. According to their model the marginal profitability of capital is a
proportion of the sales to capital ratio. If we apply this measure to a single firm we
Corporate
governance
and investment
177
need only this proportion (which is the same for each industry) and the sales to capital
ratio for each firm. This rule corresponds to a decomposition of marginal q to two
separate components, which can be attributed to both industry and firm characteristics.
One different strategy to this problem is to depart the problem of finding a good
approximation for marginal q as the average Q and try to specify the Euler
equation describing the firms optimal capital stock. This technique was applied by
Whited (1992) and Hubbard et al. (1995). The Euler equation has the advantage that it
can be extended to specify the borrowing constraint, which in the case of Whited
(1992), is inserted via debt to assets ratio and in the case of Hubbard, Kashyap,
Hubbard and Whited via credit conditions.
The third approach is based on the work of Abel and Blanchard (1986) who used a
set of financial variables as proxies for marginal q and then in a model of vector
autoregression they forecast the expected present value of current and future profits.
With this method it is possible to decompose the effect of cash flow on investment on
two different components: one related with fundamental q and the other with financial
q whereas the former is related with the investment possibilities and the latter with
capital market imperfections. This idea is also present in the work of Gilchrist and
Himmelberg (1995, 1998) aforementioned above. The idea behind these methods is that
the marginal q can be substituted by the best forecast for it made by agents having
rational expectations when they have used all available information.
However, all the methods described above, concerning the estimation of proxies for
marginal q, have different estimation requirements. The method of the average q,
irrespective of the fact that it may not be a satisfactory proxy for marginal q in the case
of incomplete markets, demands the existence of firms enlisted in the stock market in
order to formulate the market value of assets.
Although this requirement is not prohibitive in the case of developed stock markets
with large numbers of enlisted companies, it cannot be applied leaving large enough
samples for estimation to other stock markets as emergent markets. Besides this, the
exclusion of not enlisted in the stock markets firms in the empirical research in the field
it may foresee a significant part of the total population of firms which theoretically
are suspected for large information costs leading to the inequality of external and
internal cost of financing.
Leaving aside the theoretical problem of not including a representative sample of
firms, a policy issue remains. If we do not examine all of the firms, we cannot
distinguish the exact policy measures needed to solve the problem of not investing
optimally irrespective of the real cause of this distortion (asymmetric information vs
managerial discretion).
On the other side, the method of using as marginal q the forecasts of investment
fundamentals besides the estimation disadvantage of demanding large panel data with
sufficient time depth (for the VAR method to function properly) is based on an a-
theoretical method ignoring all the theoretical problems concerning the estimation of
marginal q in the presence of incomplete markets. In the case of incomplete markets the
marginal profitability of capital is affected not only by the profits to capital ratio as in
the case of the homogenous profit function used by Hayashi but from industrys
demand elasticity and other variables expressing market power.
All of these variables are included in the information which the price cost margin
conveys. So the inclusion of the price cost margin in the investment cash flow relation
reflects all the elements of market power in the industry, which are related with
demand elasticity, and concentration of the market.
MF
36,3
178
Furthermore, if we make the assumption that the price cost margin of the firm is a
fraction of the price cost margin of the industry then the marginal profitability of
capital is directly related with it. This formulation corresponds to the argument that all
that is needed at the time of the investment decision is the exact knowledge of the
market environment, which is included in the price cost margin.
To our knowledge, the relationship of investment and corporate governance has not
been researched yet in Greece. Manufacturing firms in Greece are mostly family
controlled and the major governance differences are to be found between state and
private firms as well as between foreign and domestic private firms. Banks are not
often seen to control or to manage firms in the tradition of Germany or Japan.
Ownership is also not widely dispersed since the stock market is a recent one and
Greece is still in the process of transition between emerging and mature market status.
Finally, although there are institutional provisions for official notification of firm
stakeholders changes, such provisions were not enforced and information is limited.
Our data, provided by ICAP, cover the 1992-1997 period and refer to all (2,700)
manufacturing firms producing in Greece that are obliged to publish balance sheets
and profit and loss accounts, i.e. being of a relatively large size.
On the novelty side of the paper is the inclusion of a variable in the model depicting
the expected return on the investment interacting with ownership and cash flow.
Alternative return expectations are formulated. Ownership is differentiated between
domestic and foreign firms, under the assumption that foreign firms suffer from
managerial discretion. Finally, evidence fromGreece is for the first time provided.
The paper is organized as follows: section 2 provides the conceptual framework for
the investment decision under both asymmetric information and managerial
discretion. The ownership variable is also added. Section 3 explains the Greek
particularities and displays the data. Section 4 discusses the empirical findings and
section 5 concludes and discusses future research.
2. Conceptual framework
The main interest of our study is to develop a theoretical framework capable of
discriminating between the two main alternative hypotheses: the one of asymmetric
information and the one of free cash flow or managerial hypothesis. Besides this main
characteristic, the theoretical framework must be rich enough in order to include
possible effects fromdifferent corporate governance schemes.
Vogt (1994) was the first to provide a theoretical model that was capable of
discriminating between the two hypotheses. This model assumes that there exists the
following functional dependence between investment, cash flow and investment
opportunities:
i ig. c 1
where i is investment, c is cash flow and g is a measure of investment opportunities, i.e.
Tobins average Q.
The central element of this model is the cross derivative of investment in respect to
cash flow and g. This derivative measures the sensitivity of investment to cash flow
changes when investment opportunities rise. According to Vogt i
cg
must be positive
under asymmetric information hypothesis (AIH) and negative under free cash flow
hypothesis. The positive sign under AIH is consistent with the hypothesis that the
problem of financial constraints is more severe in the firms with higher investment
Corporate
governance
and investment
179
opportunities. These firms because they are financially constrained resort to internal
cash flow more heavily than other firms, in order to exploit their high investment
opportunities.
On the other hand, the negative sign of i
cg
is related to free cash flow because this
group of firms although they have low investment opportunities tend to invest the
internal cash flow and not to pay high dividends to their shareholders. So when we
move to firms with low Tobins Q we expect under Vogts prediction an increase in the
sensitivity of investment to cash flow which leads to a negative sign. In Vogts model,
corporate governance does not matter in respect to the identification of either
asymmetric information or free cash flowproblems.
Hadlock was the first that introduced corporate governance in a theoretical
framework directly (and not indirectly as Hoshi et al., 1991, did). This theoretical
framework was able of identify the presence or not of asymmetric information
problems. Hadlock (1998) assumes that the problem of asymmetric information is
generated from the mispricing of external investors. Investors are uncertain about the
true value of firms assets, so they form expectations that are based on the amount of
the investment that the firm wants to undertake. If the firm asks for the maximum
amount then the investors are not able to discriminate between a firm with large assets
or low assets. So the firm with large assets must send a signal to them by cutting the
amount of investment. This leads to the well-known problem of under-investment that
is aggravated if there is alignment of interest between the manager and the
shareholders because in this situation the manager-owner has higher benefits/losses
fromthe mispricing. Hadlocks model has the following functional dependence between
investment, cash flow, investment opportunities and corporate governance:
i ic. c 2
where c is a variable from 0 to 1 taking the value 0 when there are no shareholdings of
the manager and 1 when the manager owns all the shareholdings. The basis for the
discrimination of both hypothesis is the sign of i
cc
, the cross derivative of investment
in respect to ownership and cash flow. According to Hadlock, when this derivative is
positive, then the sensitivity of investment to cash flow is higher when the ownership
variable moves toward its upper level. This is evidence in favor ofAIH, as in this case,
the almost perfect alignment of interests between the manager and the owner make the
external investors extremely careful in respect to the pricing of this firm, which results
in a higher risk premium. Then the solution to the problem of financing through
signaling is a heavy undercut in the desired level of funds raised from the stock market
that reduces investment below its optimal level (as it is defined by standard
neoclassical theory).
So according to these two models, a discrimination between the two fundamental
hypotheses is based on the sign of the derivative of the sensitivity of investment to cash
flow in the model of Vogt we must differentiate in respect to investment opportunities
while in the model of Hadlock in respect with ownership shareholding of managers.
However, the main difference of these models is the role of corporate governance. In the
first model corporate governance is irrelevant to both the determination of investment
and the reasons why is sensitive to cash flow, while in the second corporate governance
affects investment directly and is critical in the way we explain the sensitivity of
investment to cash flow.
MF
36,3
180
However, Hadlock neither extended his comparative static results in respect to the
rest of the variables included already in his model (as parameters) nor formed a
theoretical model which to support the free cash flow or managerial discretion
hypothesis (MDH). If we assume the same functional dependence of investment as in
(2) but we include also investment opportunities (g) in the RHS, we can estimate (see
Appendix) the cross derivative of investment in respect to cash flow and investment
opportunities (i
cg
) and in respect to investment opportunities and ownership (i
cg
). The
first of them reflects the sensitivity of investment to cash flow in respect to investment
opportunities and the second the sensitivity of investment to opportunities from
investment in respect to ownership.
What we find if we estimate i
cg
in Hadlocks model is indeed in contrast with the
results of Vogts. Under asymmetric information the sign of this derivative is negative
and not positive. This means that when we move toward higher levels of q values
(higher investment opportunities) the sensitivity of investment to cash flow must
decrease. This can be explained by the fact that in the Hadlocks model the source of
uncertainty is the true value of firms assets and not the investment opportunities. If
the latter are common knowledge and are higher then the outsiders can trade off their
uncertainty with higher returns making the financial constraint less severe. If the
financial constraint is less severe then the firm is not so dependent on internal cash
flowand the sensitivity of investment to cash flowmust be smaller.
On the other hand, i
cg
is positive which means that under Hadlocks model the
adjustment to investment opportunities in general is not the same among various
ownership structures. Firms with concentrated ownership structures adjust faster to
changing investment opportunities under asymmetric information because decision-
making is faster and less complicated.
Although these results have a twofold result by altering both the way in which
corporate governance enter the investment equation and the theoretically predicted
sign of i
cg
under different hypotheses, they do not consist a valid framework to test for
alternative hypotheses. The missing element is a model that replicates free cash flow
hypothesis with opposite signs for the cross derivatives if the previous model.
The alternative hypothesis to asymmetric information is the one about managerial
discretion. This hypothesis is based on the moral hazard aspect of our model caused by
the hidden actions of managers in the selection of the investment level. The difference
between their objective function and the one of the shareholders leads to different
selection concerning the desired level of investment. The standard theoretical
framework of this problem is the problem of principal-agent in the context of the
financial structure of the firm.
This framework was first formulated by Jensen and Meckling (1976, p. 306) with a
theory that explains . . . why an entrepreneur or manager in a firm . . . will choose a set
of activities for the firmsuch that the total value of the firmis less than it would be if he
where the sole owner. In this framework the utility function of the manager-owner
contains both the market value of his firm and the non-pecuniary benefits he receives
fromthe entrepreneurial activities, which are negatively related with market value.
Jensen and Meckling showed that with this utility scheme when there is no
coincidence between the interests of the manager and the shareholder then the market
value of the firm will be less the optimal one. Another result is that non-pecuniary
benefits will be larger than in the case where the manager and the owner are the same
person. The decrease in market value of the firm leads to the introduction of agency
costs, i.e. costs that are related with the monitoring expenditures of the principal, the
Corporate
governance
and investment
181
bonding expenditures by the agent (expenditures related with the residual loss, i.e.
reduction in welfare experienced by the principal because of the decrease in the market
value) and residual loss.
In this context of analysis, we can substitute the non-pecuniary benefits of the
manager with the non-pecuniary benefits of investment. These benefits are reflected in
the preference of the managers toward size. As in the case of non-pecuniary benefits,
investment beyond the optimal level is also negatively related with market value
because it leads to the acceptance of investment projects with negative NPV. Under
these assumptions, the manager-owner selects a combination of market value and over-
investment that maximize his utility. However when the manager and the owner are
not the same persons then the manager choose a higher level of over-investment and a
lower level of market value.
Our model is based on the following hypotheses:
(1) The first is that there is an optimal amount of investment i
e
, which is derived
from the microeconomic environment of the firm. If the firm invests optimally
then the maximum market value is the product of this level and the marginal q,
i.e. i
e
g.
(2) The second is that the managers can undertake investment projects beyond
that level because of a preference for total investment but at a cost to the market
value m per unit of investment. The total loss to the market value because of
this over-investment is m i. We assume that m 1/g, i.e. the loss from over-
investment is inversely related with marginal q. This means that the managers
select investment projects with negative net present value (NPV) but at a
declining rate. This is logical up to the point they do not want to exploit their
available resources very fast, i.e. at low levels of over-investment. This is
possible when the first derivative of min respect to g is positive, e.g. m g.
(3) There is cash flow c available large enough to cover the cost of investment. The
optimal investment level i
e
is financed by the remaining cash flowabove c.
(4) The utility function of the manager (who has convex preferences between
market value and investment) is
U V
a
i

3
From assumptions (1) and (2), we have that the market value of the firm is equal to the
maximum market value from optimal investment plus cash flow minus the cost of
over-investment:
V gi
e

1
g

i c i gi
e

1
g 1

i c 4
If we solve this constrained optimization problem we have from the firs order condition
that
i
gi
e
c
1,g 1

a

5
MF
36,3
182
The function of investment depends on the parameters of preference toward market
value and investment, the cash flowand the marginal q.
If we estimate the signs of the first order derivatives we have
0i
0a

gi
e
c
1,g 1

a

< 0
0i
0c

1
1,g 1

a

0 6
0i
0g


a

i
e
1,g 1 gi
e
c1,g
2

1,g 1
2
" #
0
The signs of the first order derivatives are the same as predicted by the asymmetric
information model and they reflect the following empirical findings:
.
Ownership matters in relation with the investment decision of the firm. If we
increase the level of managerial shareholdings investment decreases and vice
versa. Thus this intensifies the problem of under-investment and alleviates the
problem of over-investment. However, we cannot identify the exact problem that
is responsible for the importance of cash flowin the formation of the investment.
.
The importance of cash flow in the formation of investment decision may be
arise either because the firm faces a premium in external finance or because the
manager of the firm spends the cash flow of the firm to support not profitable
projects. In the first case the result is under-investment and the firm increases its
investment from internal funds, i.e. its cash flow. In the second the result is over-
investment beyond the optimal level and if the available cash flow increases then
the managers increase the investment in negative NPV projects.
.
The increase in investment opportunities expressed by the marginal q (g in our
model) tends to increase the level of investment. This is a common prediction in
all related models.
The results in relation to the cross derivatives of the model are the following:
0i
2
0a0c

1
1,g 1

a
2
!
< 0 7
This result says that the coefficient of cash flow in the investment relation decreases
with the increase in managers shareholdings of the firm. This is a typical finding in all
models of managerial discretion because in the case that the manager is the same
person with the owner then there is a less intensive incentive to exploit firms cash flow,
i.e. there exists no agency problemin this case.
0i
2
0c0g

1
1,g 1
2
!

1
g
2

0 8
Corporate
governance
and investment
183
The cross partial derivative of investment in respect to cash flow and investment
opportunities g is positive, which is in accordance with Gugler et al. (2003) but in
contrast to the theoretical finding of Vogt (1994). This result implies that the coefficient
of cash flow increases with the marginal q, which means that the problem of over-
investment is more severe for high marginal q firms than for low ones. However,
according to Vogt, this is a symptom of asymmetric information problems rather than
free cash flow considerations. But if g or marginal q is common knowledge than it is
not explained how the managers can over-invest the internal cash flow without any
counteractions from the shareholders, i.e. this finding is consistent with markets with
no corporate control. It must be the high q that enables the managers to exploit internal
capital resources in wasteful projects without any objections from the owners, i.e. over-
investment is based on investment opportunism.
0i
2
0g0a


a
2
!

i
e
1,g 1 gi
e
c1,g
2

1,g 1
2
" #
< 0 9
The cross derivative of investment in respect to ownership and marginal q is negative
which means that in this model it is possible for ownership to affect investment via the
marginal q. The decrease in the parameter for ownership is related with increased
responsiveness of investment to g increases. The managers that are not owners are
more determinant to exploit the investment opportunities not for increased market
value but because better investment opportunities are related with higher levels of non-
pecuniary benefits for them.
The policy implications of the model of managerial discretion are straightforward.
We can alleviate the over-investment problem of the firm by increasing managers
shareholdings because:
.
increased concentration of shareholdings decrease the responsiveness of
investment to cash flow;
.
increased concentration of shareholdings might decrease the responsiveness of
investment to marginal q or investment opportunities; and
.
increased shareholdings affect the size of the cross derivative of investment in
respect to cash flow and marginal-q (which is positive). With increased
shareholdings we expect the size of this derivative to be smaller.
2.1 Empirical specification
Our model suggests that investment is a function of not only cash flow (c) but also
ownership (c), and gross return from investment (g). If we divide with K, to eliminate
scale effects due to capital differences and assuming a linear form we have the
following empirical specification:
I
i
K
i
b
0
b
1
CF
i
K
i
b
2
CF
i
K
i
OWN
i

b
3
G
i
b
4
CF
i
K
i
G
i

b
5
OWN
i
G
i

10
where I
i
/K
i
is the ratio of investment I
i
to capital K
i
(the i subscript refer to firm i). As
investment for every firm we have taken the mean value of the book value (net book
value of capital plus cumulative depreciation) differences of capital in the years 1992
MF
36,3
184
and 1997 (we assume that investment is equal to the difference of continuous years
capital stock). As beginning of the period capital stock we have used the book value of
capital at 1992.
CF
i
/K
i
is the ratio of cash flow (CF
i
) to capital (K
i
). As cash flow we have used the
mean of the sum of net profits and annual depreciation for the period 1993-1997. For
the years 1993, 1994, 1995 and 1996 we have used the average growth rate of 1992-1997
to construct the corresponding values.
O
i
is the ownership value which takes the value 0 if the firm is foreign (if more than
5 percent of its equity is owned by a foreign-multinational firm) and 1 if the firm is
purely domestic. In the latter case we have a closer alignment of interests between
managers and owners. In our model O
i
is increasing from0 to 1.
G
i
is a variable expressing the gross returns on investment. Because G
i
is not
directly observed we can substitute it with other variables like price cost margin (PCM)
(of the market-industry) or return on equity (ROE) (of the firm) or a combination of the
two depending on the expectations formation mechanism we employ about G
i
. If we
use the PCM or other industry variables (like concentration ratio, size, growth, etc.), the
assumption is made that G
i
is formulated by the external environment of the firm. If we
use the ROE (or, alternatively, ROA, i.e. return on assets) of the firmwe assume that g is
mainly depending on the internal environment or the quality of the management. In the
empirical testing of our models we have used the price cost margin, the return on
equity, the return on assets and a measure of return of investment on total assets
(which resembles more to the notion of g in the our models).
The alternative hypotheses to be tested correspond to the following signs for the
coefficients of our model:
(1) If the AIHis true thenwe must have the following signs for the coefficients of (10):
b
2
0. b
4
< 0. b
5
0 11
(2) In the case that the MDH is the true one then the signs of (10) must have the
following signs:
b
2
< 0. b
4
0. b
5
< 0 12
Besides the testing of both alternative hypotheses our model in (10) can explain
whether AIH or MDI is a phenomenon related or not with corporate governance. If we
find both b
4
and b
5
to be zero than corporate governance is irrelevant to the problems
that lead to deviations from the optimal level of investment and the opposite is true
when either or both coefficients are non-zero.
3. Corporate governance in Greece and sample selection
The system of corporate governance in Greece is primarily based on the form of
the family owned firm and to a limited extent on the form of state-controlled firms. The
only difference concerning the first group of firms is the degree of participation of the
family members in the management. The small firms have a high degree of
participation of the family members in the management (in the majority of the cases
the only professional manager is the Chief Accountant) while the large firms have a
smaller family participation (which in some cases, means that the CEO is not a family
member but rather a professional manager).
Corporate
governance
and investment
185
The state-controlled firms are basically the public utilities and some other firms
which the state considers to have large importance for the regulation of some markets,
e.g. for the petroleum market. Except the public utilities, their importance is declining
due to the recent deregulation program of the government. Another group in this
category is the bank-controlled firms from banks that belong either directly or
indirectly to the state through public pension funds. This group of banks has decreased
following the recently introduced deregulation program of the banking sector. The
firms that are still controlled by state banks are basically the firms that faced liquidity
problems in the 1970s and 1980s and the control of which passed to their lenders,
which were the large state-controlled banks. Cooperatives form a separate group too.
On the other hand, the only group of firms in which there is a clear distinction
between managers and owners are the foreign or multinational firms established in
Greece. In these firms, the managers are professionals with no majority shareholdings,
while in some cases (after acquisitions), the old owners (which are now minority
shareholders) participate also in the management.
Another aspect of the system of corporate governance in Greece is the lack of
business databases with complete ownership data. This lack exists even for the listed
companies in the Athens Stock Exchange. Although capital markets legislation asks
for the public announcement of large share transfers (above 5 percent) there was no
active enforcement of the law.
Our initial sample consisted of 2,700 manufacturing firms in the period 1992-1997.
In this sample there were 170 foreign or multinational firms and 2,530 domestic ones.
Our observations refer to the years 1992 and 1997 covering the main financial data,
such as total assets, book value of capital, net profits, depreciation, etc. The data are
provided by ICAP and are supplemented by data concerning the age of the firm, its
sector, and the shares of the largest foreign shareholder. We extended our database
with information on mean (1993-1996) industry (2-digit) PCMs computed from the
Annual Industrial Surveys of the National Statistical Service (ESYE).
In order to eliminate the effect of outliers in our empirical testing we exclude from
our initial sample the upper and bottom percentiles in respect to the investment and
cash flow ratios. This results in reducing our initial sample to about 100 observations.
However, even if we exclude the outliers the investment cash flow equation is not
strongly supported by our data. The reasons for this failure are as follows:
.
According to the Greek Accounting System the firms have to adjust periodically
the book value of fixed assets in order to reflect their true economic value. One
consequence of this value adjustment is that the net investment does not
necessarily reflect the true investment in fixed assets and furthermore it is not
directly related with the cash flow.
.
Our initial sample includes firms that are not purely manufacturing firms. For
example, we have many subsidiaries of multinational firms with limited
manufacturing activity at least at their first years of operation.
.
The sample includes also relatively new small firms, which expand in
manufacturing activities at their latter years although at their first years operate
mainly as trading firms.
For this reason we search our sample for sub-samples where there exists a sensitivity
of investment to cash flow. The sensitivity increases as we move from low value of
fixed assets firms to higher ones. A reasonable value of minimum value of fixed assets
MF
36,3
186
is about 100 million drachmas (around e300,000) where a value of one billion drachmas
corresponds to a large manufacturing firm. However, the best criterion will be to divide
the firms according to the value of their machinery and plants but we did not have
access to these accounts. The sensitivity of investment to cash flow increased and
becomes significant for levels of fixed assets above the 200 million drachmas. This has
as consequence to reduce our sample at about 1,372 firms, which are purely
manufacturing firms.
The descriptive statistics of our sample is presented in Table I. Cash flow, CR-4, fixed
and total assets, age and ROA are statistical different between domestic and foreign
firms. However, there seems to be no difference in investment, price cost margins and
other market variables as sectors fixed assets and ROA. These results suggest that
domestic firms (with low cash flow) must be more sensitive to cash flow variations if
they finally attain the same level of investment with foreign firms (with high cash flow).
Table I.
Sample statistics
Mean Med. SD Obs.
Total sample
Cash flow/K 0.21 0.14 0.27 1,372
Investment/K 0.23 0.15 0.36 1,372
CR-4 0.28 0.23 0.19 1,372
L(sectors total assets) 19.55 19.92 0.93 1,372
L(firms total assets) 13.90 13.67 1.12 1,372
price cost margin 0.24 0.24 0.04 1,372
Sectors ROA 0.05 0.05 0.03 1,372
Firms ROA 0.04 0.03 0.08 1,372
Age 21.95 18.00 17.88 1,369
Foreigner firms
Cash flow/K 0.28 0.19 0.31 130*
Investment/K 0.26 0.17 0.29 130
CR-4 0.33 0.29 0.21 130*
L(sectors total assets) 19.62 19.69 0.83 130
L(firms total assets) 14.99 15.06 1.28 130*
price cost margin 0.24 0.24 0.04 130
Sectors ROA 0.05 0.07 0.03 130
Firms ROA 0.06 0.04 0.11 130*
Age 25.59 22.50 16.11 130*
Domestic firms
Cash flow/K 0.20 0.14 0.26 1,233
Investment/K 0.23 0.15 0.37 1,233
CR-4 0.27 0.23 0.19 1,233
L(sectors total assets) 19.54 19.92 0.94 1,233
L(firms total assets) 13.76 13.58 0.99 1,233
Price cost margin 0.24 0.24 0.04 1,233
Sectors ROA 0.05 0.05 0.03 1,233
Firms ROA 0.04 0.03 0.08 1,233
Age 21.55 18.00 18.06 1,230
Notes: Our initial sample contains 2,700 firms. We exclude the upper and bottom percentiles and
also firms with fixed assets below 200 million drachmas. K stands for Capital Stock in 1992 and
L for the logarithm of the variable inside the parenthesis. The asterisk denotes statistical
significant differences at 5 percent between domestic and foreign firms
Corporate
governance
and investment
187
4. Empirical findings
The empirical specification of our models is tested using various measures of gross
investment return or investment opportunities (IO) that are related with specific
assumptions about the expectation formation mechanism used to estimate returns from
investment. As the largest part of our sample do not contain firms enlisted in the stock
market it is not possible to use as a measure of marginal q, the heavily used average Q.
Besides this inability, it is not clear whether an average Qarising fromemerging markets
valuation will be an appropriate measure of investment opportunities. However, even if
we have a sufficient sample of enlisted firms with market valuation for their assets in a
non-emerging stock market it is also not clear why to exclude the not enlisted firms
because we do not have a measure for their investment opportunities. It is possible that
many not enlisted firms are not financial constrained and they not enter because of the
preference of the owners toward concentrated ownership.
Our solution to the problem of market valuation for not-enlisted to stock market
firms is to construct an average Q using a combination of both firm and industry
specific variables, i.e. to assume that there exists an equation for Qas the following:
Q QIndustry Variables. Firm Specific Variables 13
In the first group of variables we can include price cost margins (PCM), concentration
ratios (CR-4) and entry barriers as the size of invested assets (we use industrys total
assets, LMSASSETS), etc. The second group is consisting of ROA, ROI, the logarithm
of firms total assets (LMASSETS), gross margin, etc. For 48 of the firms in the sample
(which are enlisted to the stock market) it is possible to use their market valuation to
construct a Q measure with industry and firm specific variables. We first model
average Q as a combination of both industry and firm variables and then as a
combination of only firm variables. With stepwise regression we finally found the
following two equations that correspond to the two different modeling assumptions:
Q 0.20

0.10
LMASSETS 0.42

0.13
LMSASSETS 9.69

3.69
PCM 12.48

4.33
14
with adjusted R
2
0.31 and 48 observations.
Q 0.76

0.42
CR-4 0.48

0.15
LMSASSETS 8.95

4.31
PCM 10.37

3.69
15
with adjusted R
2
0.23 and 48 observations.
From (14) and (15) we can construct for every firm in our sample an approximation
to the average Q which is based on the variables that enter in these two equations. The
first equation includes one firm specific variable and two industry variables while the
second include only three industry variables. We must mention that no other
combination proved to be better in statistical terms. We name as AQ the approximation
to average Q that is produced from (14) and AQ1 the approximation from (15). We also
used PCM and LMSASSETS (logarithm of industrys total assets) in place of average Q
because these two variables are significant in both specifications.
Tables II to V present our empirical results in relation with the theoretical prediction
of Part 2. Column 1 presents the basic model with cash flow and a measure for
investment opportunities (different in each table). Column 2 includes in the basic model
the term used by Vogt (1994) while column 3 includes in the basic model the result used
MF
36,3
188
Table II.
Empirical specification
with G AQ
(1) (2) (3) (4) (5) (6)
Constant 0.04 0.06*** 0.03 0.08*** 0.03 0.08***
(0.03) (0.02) (0.03) (0.02) (0.03) (0.02)
CF/K 0.73*** 0.61*** 0.40*** 0.02 0.25** 0.16
(0.14) (0.10) (0.11) (0.27) (0.11) (0.31)
G 0.04*** 0.02 0.06*** 0.00 0.12*** 0.08**
(0.01) (0.04) (0.01) (0.04) (0.03) (0.03)
CF/K*G 0.13 0.28 0.30
(0.18) (0.21) (0.21)
CF/K*OWN 0.40*** 0.52** 0.56*** 0.71***
(0.15) (0.22) (0.18) (0.26)
G*OWN 0.08*** 0.09***
(0.03) (0.03)
Adjusted R
2
0.32 0.32 0.34 0.35 0.34 0.35
No. of observations 1,372 1,372 1,363 1,363 1,363 1,363
Notes:Where
AQ 0.20 LMASSETS 0.42 LMSASSETS 9.69 PCM 12.48
*, **, *** significant at the 10, 5 and 1 percent levels, respectively. All estimates are ordinary
least squares (OLS) with White heteroskedasticity-consistent standard errors (reported in
parentheses under the coefficient estimates)
Table III.
Empirical specification
with G AO1
(1) (2) (3) (4) (5) (6)
Constant 0.07** 0.04* 0.05* 0.05** 0.06* 0.06***
(0.03) (0.02) (0.03) (0.03) (0.03) (0.03)
CF/K 0.74*** 0.86*** 0.43*** 0.44 0.24** 0.22
(0.14) (0.14) (0.11) (0.28) (0.11) (0.32)
G 0.01 0.02 0.01 0.01 0.09*** 0.09***
(0.01) (0.03) (0.01) (0.03) (0.03) (0.03)
CF/K*G 0.08 0.00 0.01
(0.15) (0.17) (0.18)
CF/K*OWN 0.37** 0.37** 0.58*** 0.59***
(0.15) (0.19) (0.19) (0.23)
G*OWN 0.08*** 0.09
(0.02) (0.03)
Adjusted R
2
0.31 0.31 0.33 0.33 0.33 0.33
No. of observations 1,372 1,372 1,363 1,363 1,363 1,363
Notes: Where
AQ1 0.48 LMSASSETS 8.95 PCM 0.76 CR-4 10.37
*, **, *** significant at the 10, 5 and 1 percent levels, respectively. All estimates are OLS with
White heteroskedasticity-consistent standard errors (reported in parentheses under the coefficient
estimates) AQ1
Corporate
governance
and investment
189
fromHadlock (1998). Column 4 combines 2 and 3 having both terms. Column 5 includes
only cross terms related with ownership and the model in column 6 is the generalized
model with full effects fromownership and the cross termof Vogt.
In the basic model cash flow coefficient is significant at 1 percent under all different
measures for investment opportunities. However, the coefficient of investment
opportunities is not significant for AQ1 and PCM. The model of Vogt in column 2
results in insignificant cross term CF/K*G in all four specifications and cannot be used
to discriminate asymmetric or free cash flowproblems.
Table IV.
Empirical specification
with G PCM
(1) (2) (3) (4) (5) (6)
Constant 0.14*** 0.07 0.13*** 0.09 0.13*** 0.09
(0.05) (0.09) (0.05) (0.09) (0.05) (0.09)
CF/K 0.74*** 1.00*** 0.44*** 0.62 0.24** 0.41
(0.14) (0.36) (0.11) (0.50) (0.11) (0.53)
G 0.25 0.01 0.22 0.06 0.27 0.43
(0.17) (0.46) (0.17) (0.46) (0.23) (0.39)
CF/K*G 1.10 0.71 0.66
(2.00) (2.07) (2.05)
CF/K*OWN 0.36** 0.35** 0.58*** 0.57***
(0.15) (0.18) (0.19) (0.22)
G*OWN 0.55*** 0.55***
(0.15) (0.16)
Adjusted R
2
0.31 0.31 0.33 0.33 0.33 0.33
No. of observations 1,372 1,372 1,363 1,363 1,363 1,363
Notes: *, **, *** significant at the 10, 5 and 1 percent levels, respectively. All estimates are OLS
with White heteroskedasticity-consistent standard errors (reported in parentheses under the
coefficient estimates)
Table V.
Empirical specification
with G LMSASSETS
(1) (2) (3) (4) (5) (6)
Constant 0.27** 0.62 0.33** 0.45 0.34*** 0.39
(0.14) (0.37) (0.14) (0.33) (0.14) (0.33)
CF/K 0.74*** 2.47 0.43*** 1.04 0.25** 0.55
(0.14) (2.10) (0.11) (1.85) (0.11) (1.82)
G 0.02*** 0.04** 0.02*** 0.03* 0.03*** 0.03*
(0.01) (0.02) (0.01) (0.02) (0.01) (0.02)
CF/K*G 0.09 0.03 0.01
(0.10) (0.09) (0.09)
CF/K*OWN 0.37** 0.36*** 0.57*** 0.56***
(0.15) (0.14) (0.19) (0.18)
G*OWN 0.01*** 0.01***
(0.00) (0.00)
Adjusted R
2
0.31 0.31 0.33 0.33 0.34 0.34
No. of observations 1,372 1,372 1,363 1,363 1,363 1,363
Notes: *, **, *** significant at the 10, 5 and 1 percent levels, respectively. All estimates are OLS
with White heteroskedasticity-consistent standard errors (reported in parentheses under the
coefficient estimates)
MF
36,3
190
The model with the cross term of Hadlock (column 3) is better performing with the
cross term (CF/K*OWN) significant at 5 percent in all four models. With this
specification, cash flowcoefficient drops at lower levels (0.40-0.44 instead of 0.73-0.74 in
the basic model) and the difference is reflected in the magnitude of the coefficient of the
cross term. Increased ownership results in 0.36-0.40 higher coefficient for these firms in
relation with foreigner ones. This finding is in favor of asymmetric information
problems for ownership concentrated firms.
If we include both results in order to lead these model in direct confrontation we find
again no significance for the cross term of cash flow and Q. The cross term of cash flow
and ownership was instead significant in all models and positive, supporting the
existence of asymmetric information problems. In column 5 we present our model with
ownership effects entering both through cash flow and investment opportunities.
We found both cross effects to be significant at the 1 percent level and opposite in
sign. This evidence indicates the presence of both asymmetric information and
free cash flow problems. The positive coefficient of CF/K*OWN indicates higher
investment-cash flow sensitivities for highly concentrated firms (in terms of
ownership) but the negative coefficient of OWN*G is evidence of free cash flow effects
through the adjustment mechanism to investment opportunities. So although domestic
firms are more sensitive to the variations of cash flow, foreign firms are more
responsive to variations in investment opportunities.
The same results of the model in column 5 are also present in the generalized model
of column 6, which includes all possible effects. Ownership effects to cash flow are
important in all four models while ownership effects through investment opportunities
are significant in three out of four models. The cross effect in cash flow through
investment opportunities is not supported in all models.
Another interesting topic is whether these empirical findings are supported under
various categorizations of firms. This is important because many empirical researches
before and after the seminal work of Hoshi et al. (1991) related asymmetric information
and free cash flow problems with the specific characteristics of firms (other than
ownership). For example, Kadapakkam et al. (1998), Harhoff (1996) and Vogt (1994)
used as separating criterion the size of the firm. Others as Hoshi et al. (1991) and
Schaller (1993) used firm age. Under these criteria asymmetric information is a
problem related with small, young, and fast growing firms while free cash flow
problems was more probable in large, old and slowgrowing firms.
In Tables VI and VII we divide our sample in three groups according to age and
size[1]. In Table VI we used for investment opportunities the estimates from (14) and in
Table VII the logarithm of industrys fixed assets (LMSASSETS). If we measure
investment opportunities with (14) and divide our sample in terms of age we find that
the best model corresponds to the medium class. Group 2 has all its coefficients
statistically significant. It is also the first time we found the coefficient of cash flow to
investment opportunities (CF/K*G) to be significant. However from the signs of the
coefficients, Group 2 does not fundamentally changes our initial findings. Asymmetric
information problems are present through the negative sign of CF/K*G coefficient and
the positive coefficient of CF/K*OWN. On the other hand, the negative coefficient of
OWN*G is indicative of free cash flow problems related with the adjustment of
investment to variations in investment opportunities. Similar results are obtained if we
measure investment opportunities with industrys total assets (entry barriers) although
in this case the coefficient of CF/K*G was insignificant.
Corporate
governance
and investment
191
On the other hand, in Group 3 the generalized model was completely unsatisfactorily
while in Group 1 we found evidence in favor of asymmetric information through
ownership cash flow coefficient. CF/K*G coefficient was either insignificant or nearly
insignificant.
The categorization according to assets size reveals that the best fitting for the
generalized model is obtained at the upper class. If we measure investment
Table VII.
Empirical specification
with G LMSASSETS
Age
group 1
Age
group 2
Age
group 3
Assets size
group 1
Assets size
group 2
Assets size
group 3
Constant 0.74 0.31 0.28 0.22 0.05 1.04*
(0.46) (0.25) (0.37) (0.28) (0.57) (0.55)
CF/K 1.42 0.51 3.97* 3.05 1.69 4.73*
(2.13) (1.30) (2.42) (1.96) (3.23) (2.72)
G 0.05** 0.03** 0.01 0.00 0.01 0.06**
(0.02) (0.01) (0.02) (0.02) (0.03) (0.03)
CF/K*G 0.08 0.02 0.22* 0.16 0.11 0.22*
(0.11) (0.06) (0.12) (0.10) (0.16) (0.13)
CF/K*OWN 1.16*** 0.44*** 0.29 0.45*** 0.02 0.68***
(0.33) (0.14) (0.34) (0.14) (0.28) (0.19)
G*OWN 0.01* 0.01*** 0.00 0.01 0.00 0.01***
(0.00) (0.00) (0.00) (0.01) (0.00) (0.00)
Adjusted R
2
0.50 0.46 0.16 0.35 0.10 0.57
No. of observations 438 404 447 450 458 455
Notes: *, **, *** significant at the 10, 5 and 1 percent levels, respectively. All estimates are OLS
with White heteroskedasticity-consistent standard errors (reported in parentheses under the
coefficient estimates)
Table VI.
Empirical specification
with G AQ
Age
group 1
Age
group 2
Age
group 3
Assets size
group 1
Assets size
group 2
Assets size
group 3
Constant 0.11*** 0.02 0.11*** 0.08*** 0.11*** 0.06*
(0.03) (0.03) (0.02) (0.02) (0.02) (0.03)
CF/K 0.81 0.61*** 0.18 0.16 0.10 0.00
(0.49) (0.17) (0.43) (0.30) (0.38) (0.39)
G 0.06 0.19*** 0.01 0.18 0.11 0.09*
(0.08) (0.05) (0.05) (0.17) (0.08) (0.04)
CF/K*G 0.67* 0.29*** 0.40 0.18 0.31 0.18
(0.36) (0.11) (0.26) (0.18) (0.39) (0.26)
CF/K*OWN 1.26*** 0.26*** 0.39 0.60** 0.39 0.88***
(0.39) (0.10) (0.39) (0.25) (0.30) (0.34)
G*OWN 0.12 0.11*** 0.03 0.17 0.08 0.13***
(0.09) (0.04) (0.04) (0.17) (0.07) (0.04)
Adjusted R
2
0.56 0.49 0.17 0.34 0.12 0.56
No. of observations 438 404 447 450 458 455
Notes: *, **, *** significant at the 10, 5 and 1 percent levels, respectively. All estimates are OLS
with White heteroskedasticity-consistent standard errors (reported in parentheses under the
coefficient estimates)
MF
36,3
192
opportunities with entry barriers (LMSASSETS) then all coefficients are significant
and especially the ones related with ownership. Asymmetric information problems are
present both through ownership and investment opportunities[2]. Free cash flow or
managerial discretion problems are present through the coefficient of OWN*G. The
latter effect is considerably greater if we measure G with estimates from (14). In
the medium group of total assets we did not find any significance for the coefficients of
the generalized model while in group 1 we found evidence in favor of asymmetric
information problems only through cash flow and ownership coefficient. The cash flow
coefficient itself was insignificant.
The conclusion from these results is that asymmetric information problems or
managerial discretion problems are irrelevant in respect to firms age. The fact that the
generalized model has superior fitting in the medium class cannot support differences
in investment behavior on the basis of firms age.
However the same is not true in respect to firms size. The best fitting is obtained
from the largest asset size group indicating that this group presents more severe
problems of asymmetric information or free cash flow problems. On the other hand, the
generalized model supports the presence of asymmetric information problems in the
small assets size group through ownership. These results are inconclusive in respect
with the question of the real source of information problems, i.e. if they are related with
size or not. However in general, less concentrated ownership is more possible in large
firms than in small firms. On the other hand, the exact causation between size and
ownership is not quite obvious but our separation of firms (foreigner versus domestic)
indicates that it is impossible for the owners of multinational firms to be managers of
their subsidiaries at the same time irrespective of their size. This supports the
hypothesis that the real source of the information problems in our study, are related
primarily with ownership not with size. This does not hold in respect with managerial
discretion problems because (as the data reveal) it is the large size that enables the
managers of foreigner firms to be more sensitive to variations in investment
opportunities in comparison with domestic firms.
In respect to the robustness of our results Table VIII shows that by increasing the
fixed assets size we can increase the overall performance of the generalized model.
Both cash flow and investment opportunities coefficients increase in significance as we
move toward larger fixed assets sizes. On the other hand, the coefficient of cash flow
and AQ is insignificant at lower fixed assets size but it gradually becomes negative
and significant. Ownership effects in respect to AQ are significant at all levels of fixed
assets but ownership effects in respect to cash flow are significant at all classes but
with varying levels of significance. Another interesting result is that the latter effect is
decreasing in magnitude up to the last class of assets where it is high again.
Another aspect related with the robustness of our results is whether our average Q
approximations are robust to the method of estimation that we used. Our initial
estimation is based on a parametric estimation of the variable AQ using a set of
industry and firm specific variables. Alternatively, we can use non-parametric
techniques (Hardle, 1990). In this case the model has the form:
Y mX
where Yis a N 1 vector and X is N P vector. M(x) is the conditional expectation of
Y with no specific parametric form and the density of the term is unspecified. Then
the N observations Yand X are used to estimate the joint density function for Yand X.
Corporate
governance
and investment
193
The density at a point (Y
0
, X
0
) is estimated with the proportion of the N observations
that are close to this point. This technique is based on a weighing function (kernel
function) that defines the closeness to the point (Y
0
, X
0
). By estimating the joint
probability distribution it is also possible to estimate the marginal distribution of X (by
integrating the joint probability over Y) and then the conditional distribution of Y
given X (which equals the ratio of the joint to the marginal distribution). Then the
estimation of m(X) has the following form:
^ mm
h
x
P
N
i1
Kx
i1
x
1
,h
1
. . . . . x
ip
x
p
,h
p
y
i
P
N
i1
Kx
i1
x
1
,h
1
. . . . . x
ip
x
p
,h
p

The parameter h is the bandwidth (known also as the smoothing parameter) and is
necessary for the definition of the distance of the observation from the central value
(x
01
, . . ., x
0p
). The function K() is the kernel function that is used for the weighting of
the observations from the central values. As kernel functions we can use various
distribution functions, i.e. the uniform, the triangle, the Epanechnikov, the Gauss, etc.
For the non-parametric estimation of the investment opportunities we used the
industry specific explanatory variables that we use for the estimation of the investment
opportunities AQ1 (CR-4, Industrys Total Assets and Industrys Price Cost Margins).
The estimation of investment opportunities with non-parametric regression
(AQNP) was calculated with the kernel function of the normal distribution with the
statistical program XploRe (v.4) and then the estimations were used in the generalized
investment cash flowmodel. The relative results are presented in Table IX.
Table VIII.
Empirical specification
with G AQ
FA >
200,000
FA >
400,000
FA >
800,000
FA >
1,000,000
FA >
1,200,000
FA >
1,400,000
Constant 0.08*** 0.04 0.02 0.03 0.02 0.01
(0.02) (0.03) (0.04) (0.04) (0.03) (0.04)
CF/K 0.16 0.53** 0.76** 0.76** 0.88*** 0.70***
(0.31) (0.27) (0.31) (0.34) (0.26) (0.17)
G 0.08** 0.10*** 0.11*** 0.10*** 0.11*** 0.12***
(0.03) (0.03) (0.03) (0.03) (0.03) (0.03)
CF/K*G 0.30 0.17 0.29* 0.28* 0.37*** 0.33***
(0.21) (0.14) (0.16) (0.170 (0.11) (0.10)
CF/K*OWN 0.71*** 0.50*** 0.38** 0.41** 0.32* 0.50***
(0.26) (0.19) (0.18) (0.20) (0.17) (0.09)
G*OWN 0.09*** 0.07*** 0.07*** 0.07*** 0.07*** 0.08***
(0.03) (0.02) (0.02) (0.02) (0.02) (0.02)
Adjusted R
2
0.35 0.31 0.45 0.46 0.44 0.56
No. of observations 1,363 871 501 422 358 311
Notes: Where
AQ 0.20 LMASSETS 0.42 LMSASSETS 9.69 PCM 12.48
FA: fixed assets in thousands drachmas; *, **, *** significant at the 10, 5 and 1 percent levels,
respectively. All estimates are OLS with White heteroskedasticity-consistent standard errors
(reported in parentheses under the coefficient estimates)
MF
36,3
194
The results in Table IX verify the results with parametric estimation of investment
opportunities, as all coefficients are found significant with the same signs. These
results support the hypothesis of asymmetric information problems as it is shown in
the signs of the combined terms CF/K*G and CF/K*OWN.
5. Conclusions and future research
The standard theoretical model of the investment-cash flowrelationship was extended to
cover the effects of different investment returns arising either fromfirmspecific variables
or from industry ones. We also include in our model all the interaction terms that affect
the investment ratio and are related with the ownership variable. All these terms can be
very useful in the testing of our main alternative hypotheses, as our theoretical
predictions are very specific about their sign under either the AIH or the MDH. An
additional point in out testing is that it provides a framework for the inclusion of all the
examined so far in the literature interaction terms, namely the interaction of cash
flowand marginal q (Vogt, 1994) and ownership and cash flow(Hadlock, 1998).
The extensions of our empirical model are based on the predictions of the theoretical
models we used. For the AIH we used an extensive form of a previous model (Hadlock,
1998) solving the investment to its determinants namely the cash flow, the gross returns
frominvestment and the ownership variable. We present also a model based on the MDH
using convex preferences of the managers toward market value and firm size, which has
comparative static results opposite in signwith the asymmetric information model.
Our models in general confirm the theoretical predictions of other similar models in
the literature. The only exception is the sign of the interaction term of cash flow and
return under AIH and MDH. Vogts (1994) prediction using financial formulas that this
term must be positive under AIH and negative under MDH prevailed in the recent
empirical literature although others as Gugler et al. (2003) adopt the opposite signs. We
Table IX.
Empirical specification
with G AQNP
(1) (2) (3) (4) (5) (6)
C 0.08 0.53* 0.06 0.48* 0.07 0.46*
(0.07) (0.28) (0.07) (0.26) (0.07) (0.25)
CF/K 0.82*** 4.21** 0.44*** 3.49** 0.24** 3.21**
(0.17) (1.78) (0.12) (1.57) (0.12) (1.54)
G 0.01 0.38** 0.01 0.35** 0.09* 0.41***
(0.06) (0.16) (0.05) (0.15) (0.05) (0.16)
CF/K*G 2.14** 1.91** 1.84**
(1.05) (0.96) (0.94)
CF/K*OWN 0.48*** 0.43*** 0.71*** 0.63***
(0.18) (0.15) (0.21) (0.17)
G*OWN 0.10*** 0.09***
(0.03) (0.02)
Adjusted R
2
0.34 0.37 0.37 0.39 0.38 0.40
No. of observations 1,019 1,019 1,014 1,014 1,014 1,014
Notes: Where
AQNP mCR-4. LMSASSETS. PCM
*, **, *** significant at the 10, 5 and 1 percent levels, respectively. All estimates are OLS with White
heteroskedasticity-consistent standard errors (reported in parentheses under the coefficient estimates)
Corporate
governance
and investment
195
think that our theoretical models can help in the direction of resolving this controversy,
which has essential consequences in the testing of the alternative hypotheses.
Another aspect of our paper is that the ownership variable varies with the
nationality of the shareholders of the firm and not with the shareholdings of the
managers as it commonly used in the literature.
Our main empirical conclusion is that ownership matter in the formation of
investment behavior. Although the evidence is not absolutely clear in some sub-
samples, in some others and under specific assumptions concerning the investment,
the evidence are in favor of the AIH. The interaction terms have also significant
explanatory power in the investment equation. The inclusion of an interaction term
between price cost margin and cash flow or ownership is accepted in most cases
providing evidence either for the AIH or the MDH.
Another dimension of our model is the mechanism used by managers to form
expectations about the gross returns on investment. At the time of selection of the
investment expenses the managers can either use industry wide measures, such as
price cost margins or firm specific measures, such as returns on equity. A combination
of the two measures can also be used. Our empirical findings support the hypothesis
that this mechanism is primarily affected by industry wide variables rather than from
firmspecific ones, such as the return on equity or the combination of the two.
The empirical research in this field based on our database can be easily extended to
expand the ownership data with respect to the foreign or multinational firms. From the
available data, we can define three categories of ownership in the multinational group:
majority, minority and full ownership foreign firms. We can also extend our database with
respect to the domestic group to cover separately the private and state-controlled firms.
Furthermore, the investment behavior of family owned firms with respect to two groups
depending on if there is a familyor professional managing director can be examined.
Notes
1. Measured through the logarithm of total assets. Group 1 corresponds to the lower values
and Group 3 to the higher ones.
2. If we use entry barriers. However if we use estimates from Equation (14), the coefficient
is insignificant.
References
Abel, A.B. and Blanchard, O.J. (1986), The present value of profits and cyclical movements in
investment, Econometrica, Vol. 54 No. 2, pp. 249-73.
Fazzari, S.M., Hubbard, R.G. and Petersen, B.C. (1988), Financing constraints and corporate
investment, Brookings Papers on Economic Activity, Vol. 1, pp. 141-95.
Gilchrist, S. and Himmelberg, C. (1995), Evidence on the role of cash flow in investment, Journal
of Monetary Economics, Vol. 36, pp. 541-72.
Gilchrist, S. and Himmelberg, C. (1998), Investment, fundamentals and finance, Working Paper
No. 6652, NBER, Cambridge, MA.
Gugler, K., Mueller, D.C. and Yurtoglu, B.B. (2003), Marginal q, average q, cash flow and
investment, Southern Economic Journal, Vol. 70 No. 3, pp. 512-32.
Hadlock, C.J. (1998), Ownership, liquidity, and investment, RAND Journal of Economics,
Vol. 29, pp. 487-508.
Hardle, W.K. (1990), Applied nonparametric regression, Econometric Society Monographs No.
19, Cambridge University Press, Cambridge.
MF
36,3
196
Harhoff, D. (1996), Financing Constraints in R&D A Panel Data Study of German Firms 1987-
1994, Zentrumfur Europaische Wirtschaftsforschung, Mannheim.
Hayashi, F. (1982), Tobins marginal Qand average Q, Econometrica, Vol. 50 No. 1, pp. 213-24.
Hoshi, T., Kashyap, A. and Scharfstein, D. (1991), Corporate structure, liquidity, and investment:
evidence from Japanese industrial groups, Quarterly Journal of Economics, Vol. 106,
pp. 33-60.
Hubbard, R.G., Kashyap, A.K. and Whited, T.M. (1995), Internal finance and firm investment,
Journal of Money, Credit, and Banking, Vol. 27, pp. 683-701.
Jensen, M.C. (1986), Agency costs of free cash flow, corporate finance, and takeovers, American
Economic Review, Vol. 76, pp. 323-9.
Jensen, M.C. and Meckling, W. (1976), Theory of the firm: managerial behavour, agency costs
and ownership structure, Journal of Financial Economics, Vol. 3, pp. 305-60.
Kadapakkam, P., Kumar, R.P.C. and Riddick, L.A. (1998), The impact of cash flows and firm size on
investment: the international evidence, Journal of Banking &Finance, Vol. 22, pp. 293-320.
Kaplan, S.N. and Zingales, L. (1995), Do financing constraints explain why investment is
correlated with cash flow?, Working Paper No. 5267, NBER, Cambridge, MA.
Kaplan, S.N. and Zingales, L. (1997), Do investment-cash flow sensitivities provide useful
measures of financing constraints?, Quarterly Journal of Economics, Vol. 112, pp. 169-215.
Modigliani, F. and Miller, M.H. (1958), The cost of capital, corporation finance, and the theory of
investment, American Economic Review, Vol. 48 No. 3, pp. 261-97.
Myers, S.C. and Majluf, N.S. (1984), Corporate financing and investment decisions when firms have
information that investors do not have, Journal of Financial Economics, Vol. 13, pp. 187-221.
Schaller, H. (1993), Asymmetric information, liquidity constraints, and canadian investment,
Canadian Journal of Economics, Vol. 26, pp. 552-74.
Tobin, J. (1969), A general equilibrium approach to monetary theory, Journal of Money, Credit
and Banking, Vol. 1 No. 1, pp. 15-29.
Vogt, S.T. (1994), The cash flow/investment relationship: evidence from US manufacturing
firms, Financial Management, Vol. 23, pp. 3-20.
Whited, T.M. (1992), Debt, liquidity constraints, and corporate investment, Journal of Finance,
Vol. 47, pp. 1425-59.
Further reading
Fazzari, S.M. and Petersen, B.C. (1993), Working capital and fixed investment: new evidence on
financing constraints, RANDJournal of Economics, Vol. 24, pp. 328-42.
Gugler, K. (1999), Investment spending in Austria: asymmetric information versus managerial
information, mimeo, Department of Economics, University of Vienna.
Stulz, R. (1990), Managerial discretion and optimal financing policies, Journal of Financial
Economics, Vol. 26, pp. 3-27.
Appendix
Asymmetric information model
Our first model is based on Hadlocks (1988) with the additional assumption that investment is a
function of not only c (a parameter value showing the alignment of interests between firms
managers and owners) and c (cash flow) but also of g (gross returns from investment). With this
modification we reach more extensive comparative static results, which enable us to extend the
regression specification most commonly used in the literature.
The model used by Hadlock has the following timing: The game is extended in three time
periods. At time 0 the firm has assets in place A, and realizes a cash flow c. At time 1 the firm
Corporate
governance
and investment
197
makes a financing decision by choosing a quantity e of external funds to raise froman equity issue.
After raising the external funs, it chooses an investment level A
h
. At date 2 the firm is liquidated
for a sum equal to the value of time 0 assets in place, plus the returns from the date 1 investment
funds. There is no discounting and the gross returns from the date 1 investment are g i, where
g > 1.We also assume that investing at any level above i
e
generates no additional returns above g
i
e
, and we further assume that managers are constrained to invest at or below the efficient level i
e
.
Finally, we assume c < i
e
, so that the firmneeds to invest external funds to invest efficiently.
There is asymmetric information concerning the exact value of the firms assets in place at
the time of the equity issue decision. Although the manager of the firm knows the exact value,
which is either A
h
(high-type firm) or A
l
(low-type firm), the potential investors assign
probability p that the firm is of the high-type and 1 p of the low-type. The financing decision
can be modeled as a signaling game. Managers first announce e, the quantity of external funds
they will rise. The investors formulate beliefs about the firms type and equity prices so that a
fraction s(e) of the firmmust be sold in newequity to raise e.
Given a set of beliefs and an announcement e, the markets expected value of the firms assets
in place is Aejj jeA
h
1 jeA
l
. The manager has the following utility function:
a1 si cjjA
j
gi i 1
0

where sejj e,Aejj gc eis the share of the new shareholders, which implies that the
manager acts for the interests of the old shareholders (given by the parameter c) and has also a
preference (given by the parameter ) for size (or growth) which affects his financing decisions.
The objective of the manager is to choose i 2 c. i
e
to maximize (1).
Hadlock derives the following separating equilibriumcondition for this problem:
ag 1 i
e
i a
A
h
A
l
A
h
gi
i c 2
0

This solution corresponds to an implicit function of the form:

Fi. a. c. g ag 1 i
e
i a
A
h
A
l
A
h
gi
i c 3
0

which implies that there exists a functional dependence among investment and the parameters of
our problemof the form:
i ia. g. c 4
0

The comparative static analysis of our model can be completed if we find the sign of the implicit
function derivatives:
i
a

f
a
f
i
. i
c

f
c
f
i
. i
g

f
g
f
i
. i

f
i
5
0

where
f
i
ag 1 A
h
gi gi
e
i aA
f
a
A
h
gii
e
ig 1 Ai c
f
c
aA
f
g
i
e
iiag 1 i
e
iA
h
gia
f

A
h
gii
e
i
we set A A
h
A
l

MF
36,3
198
with
f
i
< 0. f
a
< 0. f
c
0. f
g
0. f

0 6
0

The second derivative is negative because

f
a
< 0 , A
h
gii
e
ig 1 Ai c < 0 ,
A
h
gii
e
ig 1 < Ai c , ag 1i
e
i <
aAi c
A
h
gi
, ag 1i
e
i <
aAi c
A
h
gi
ag 1 i
e
i
7
0

The signs of the derivatives of the implicit function, determine the exact signs of the partial
derivatives of the investment equation:
i
a

f
a
f
i
< 0. i
c

f
c
f
i
0. i
g

f
g
f
i
0. i

f
i
0 8
0

The comparative static analysis of our model can be completed with the signs of the cross partial
derivatives.
For the partial derivative of the investment equation with respect of c and g we have the
following result:
i
c

f
c
f
i

aA
ag 1 A
h
gi gi
e
i aA
9
0

which implies that

i
cg

0
0g

f
c
f
i

0
0g
aA
ag 1 A
h
gi gi
e
i aA

aA1
aA
h
gi gi
e
i ag 1 i gi
g
2 i
e

fag 1 A
h
gi gi
e
i aAg
2
10
0

The sign of the whole expression depends on the sign of the numerator and finally on the sign of
the expression:
aA
h
gi gi
e
i ag 1 i
e
i 0
ag 1 i
e
i
aAi c
A
h
gi
<
aAi
A
h
gi
< ai
aA
h
gi gi
e
i ai
aAi
A
h
gi

aAi c
A
h
gi
ag 1 i
e
i
11
0

The numerator is positive which implies that the cross partial derivative is negative, i.e. i
cg
< 0.
Corporate
governance
and investment
199
For the partial derivative of the investment equation with respect of c and c we have the
following result:
i
ac

0
0a

f
c
f
i

0
0a
aA
ag 1 A
h
gi gi
e
i aA

A
fag 1 A
h
gi gi
e
i aAg ag 1A
h
gi gi
e
i
ag 1 2gi
a
A
fag 1 A
h
gi gi
e
i aAg
2
A
A
h
gi gi
e
i aag 1 2gi
a

fag 1 A
h
gi gi
e
i aAg
2
12
0

The numerator of this expression is positive because i

c
< 0, so the derivative is positive, i.e.
i
cc
> 0. The next step is to derive the sign of investment with respect to g and a:
i
ga

0
0g

f
a
f
i

0
0g
,ai
e
iA
h
gi
ag 1 A
h
gi gi
e
i aA

,a
A
h
gii
g
i
e
ii gi
g
K i
e
iA
h
giL
fag 1 A
h
gi gi
e
i aAg
2
13
0

For simplification of the expression above we set

K ag 1 A
h
gi gi
e
i aA
L aA
h
gi gi
e
i ag 1 i gi
g
2 i
e

14
0

The first expression is positive because by assumption we have A

h
> i
e
> g(i
e
i).
The second expression is the numerator of i
cg
, for which we have shown that it is positive.
The sign of the derivative depends on the sign of the expression:
A
h
gii
g
i
e
ii gi
g
< 0
, i
e
ii < i
g
A
h
gi gi
e
i
,
i
e
ii
A
h
gi gi
e
i
< i
g
,
i
e
ii
A
h
gi gi
e
i
<
i
e
iiag 1 i
e
iA
h
gia
ag 1 A
h
gi gi
e
i aA
, i < A
h
gi gi
e
i
15
0

which means that the numerator is negative. So the derivative is positive, i.e., i
cg
> 0.
To summarize the analysis of the investment equation behind our model we have the
following results:
i
a
< 0. i
ag
0. i
cg
< 0
i
g
0. i
ac
0
i
c
0
16
0

The results i
c
< 0, i
c
> 0, i
g
> 0 are the same results reported in Hadlock (1988) and are
consistent with both the asymmetric information and the free cash flow hypothesis. If there is an
increase in the alignment between firms managers and owners (affecting c) then there is an
under-investment problem and if there is an increase in the cash flow (affecting c) there is
over-investment or a free cash flow problem. However, the combined increase of both c and c (i
cc
)
MF
36,3
200
tends to increase the investment which means that the sensitivity of investment to cash flow
tends to increase when c increases and the firm faces asymmetric information or free cash flow
problems.
The new results are the partial derivatives i
cg
and i
cg
. The result i
cg
< 0, implies that this
sensitivity (of investment to cash flows) decreases with an increase in g. This result implies that
in sectors with high gross returns from investment, we expect a reduction of investment-cash
flow sensitivity in this model as firms with high investment opportunities can alleviate their
financial constraint. The underlying assumption is that these investment opportunities are a
common knowledge in the market, which is a valid assumption as far as investment
opportunities are reflected in Qratios that are based on market valuations, i.e. the expectations of
the investors about future profitability.
The result i
cg
> 0, implies that the interaction of high ownership and gross returns levels is
related with increasing investment levels. This is easily explained because more concentrated
firms are more eager to exploit investment opportunities in order to benefit from increased
market valuations. Besides this argument concentrated firms are possible more flexible and less
bureaucratic in undertaking newprojects.
Corresponding author
Afroditi Papadaki can be contacted at: afroditi.papadaki@aueb.gr
To purchase reprints of this article please e-mail: reprints@emeraldinsight.com
Or visit our web site for further details: www.emeraldinsight.com/reprints