Capital Investment and Earnings: International Evidence

• Date: 01 September 2009
• Author: Jungwon Suh,Ahmet Can Inci,Bong Soo Lee
• Published date: 01 September 2009
• DOI: http://doi.org/10.1111/j.1467-8683.2009.00749.x

Capital Investment and Earnings: International

Evidence

Ahmet Can Inci, Bong Soo Lee*, and Jungwon Suh

ABSTRACT

Manuscript Type: Empiricalcorg_749526..545

Research Question/Issue: We examine the nature of the dynamic linkage (causality) between earnings and capital invest-

ment using f‌irm-level data from around the world to see whether the legal environment, including corporate governance

and monitoring mechanisms, and f‌inancial development are important in the prof‌itability of capital investment.

Research Findings/Insights: Using f‌irms in 40 countries over the period 1988–2004, we f‌ind that the causality from earnings

to capital investment is positive and strong in almost all countries, irrespective of the type of legal system and the degree

of f‌inancial development. However, the causality from capital investment to earnings is generally negative for f‌irms in civil

law and f‌inancially undeveloped countries, while the causality is generally positive in common law and f‌inancially

developed countries. Therefore, our international cross-country study enables us to f‌ind that the legal system and f‌inancial

development are factors in the determination of the prof‌itability of capital investment.

Theoretical/Academic Implications: Our f‌indings imply that internal f‌inancing is a signif‌icant constraint for capital

investment, which provides support for the pecking order theory even for f‌inancially developed markets and for the free

cash f‌low theory.Common law and f‌inancially developed countries tend to providebetter shareholder protection with more

eff‌icient corporate governance and better investment decisions.

Practitioner/Policy Implications: To encourage managers to make capital investments in value-increasing projects, it is

important to further improve a legal environment that includes corporate governance, monitoring, and incentive mecha-

nisms. Financial development that includes effective f‌inancial regulatory agencies should be sought.

Keywords: Corporate Governance, Capital Investment, Earnings, Pecking Order Theory, Legal System, Financial

Development

INTRODUCTION

Corporate f‌inance models assume that managers make

investment decisions in order to maximize f‌irm value.

The fundamental “textbook” investment decision criterion

is to accept projects with a positive net present value. Mc-

Connell and Muscarella (1985) have presented evidence that

managers act as value maximizers when setting investment

policy. To draw stronger implications with regard to the

nature of managerial investment decisions, the dynamic

relation between earnings and capital investment has been

examined by Bar-Yosef, Callen, and Livnat (1987) and Lee

and Nohel (1997). The former study shows that there is a

Granger causality relation from earnings to capital invest-

ment, but not vice versa. On the other hand, the Lee and

Nohel (1997) study f‌inds that not only earnings Granger-

cause capital investment, but capital investment also

Granger-causes earnings.1

In this study, we examine the issue from an international,

cross-country perspective. Using f‌irm-level data from 40

countries over the period 1988–2004, we investigate how

earnings inf‌luence capital investment and how capital

investment inf‌luences earnings. Our study is the f‌irst to

examine the nature of the dynamic linkage between earnings

and capital investment using f‌irm-level data from around

the world. The two prior studies on this topic, Bar-Yosef,

Callen, and Livnat (1987) and Lee and Nohel (1997), only

examine US f‌irms. However, the dynamic linkage may

depend on governance relations, and it has been docu-

mented that governance relations can be quite different

outside of the US (e.g., Shen & Chih, 2007; Singh & Zammit,

2006; Zattoni & Cuomo, 2008). Therefore, the motivation for

the cross-country study using international data is clear. The

dynamic linkage of earnings and capital investment (i.e., the

causal relation) can vary across different legal systems

*Address for correspondence: Department of Finance, College of Business, Florida

State University, Tallahassee, FL 32306-111 b, USA. Tel: 850-644-4713; Fax: 850-644-

4225; E-mail: blee2@cob.fsu.edu

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Corporate Governance: An International Review, 2009, 17(5): 526–545

© 2009 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00749.x

and maturity of f‌inancial markets. The cross-country study

allows us to examine the dynamic relation in various con-

texts including the legal system, f‌inancial development, cor-

porate governance mechanisms, level of insider ownership,

and economic development.

We f‌ind that earnings Granger-cause capital investment

and that the net (cumulative) effect of earnings on subse-

quent investments is positive in both civil law and common

law countries. The f‌inding suggests that internal f‌inancing is

a signif‌icant constraint for investment. However, the evi-

dence that capital investment Granger-causes earnings is

relatively weak and its net effect is positive, although not

very signif‌icant, in common law and developed countries,

but it is signif‌icantly negative and value decreasing in civil

law and developing countries. This implies that corporate

managers in common law countries, which have stronger

corporate governance or monitoring mechanisms, tend to

make better capital investment decisions. Furthermore,

when insider ownership is high in developing civil law

country f‌irms, capital investment increases earnings. This

implies that the lack of corporate governance mechanisms

and shareholder protection in these f‌irms are partly coun-

tered by higher levels of insider ownership.

These results are robust in the use of cash f‌lows in lieu of

earnings. Introducing year dummies as additional explana-

tory variables makes little difference. Using changes in earn-

ings and changes in capital investment in lieu of level

variables does not alter the results. The capital investment-

to-earnings causality f‌inding becomes more pronounced

during recessions, which implies that the benef‌its of corpo-

rate governance, shareholder protection, and monitoring

mechanisms are most pronounced during recessions.

Therest of the paper is organized as follows. Wepresent the

theoretical development and methodology. We also discuss

the causal relations between earnings (or cash f‌lows) and

capital investment. Next, we describe the data. This is fol-

lowed by the analyses of the cross-countrydifferences in the

causal relations, focusing on the effect of the legal environ-

ment, the level of f‌inancial development, the implications of

insider ownership and agency conf‌licts. Then, we conclude.

THEORETICAL DEVELOPMENT AND

METHODOLOGY

A study of the dynamic causal relation between earnings

and capital investment is related to several strands of litera-

ture in f‌inance. In developing the hypotheses, we postulate

that the direction and strength of the causalitybetween earn-

ings and capital investment can be affected by corporate

governance environments (i.e., legal systems) and the matu-

rity of f‌inancial markets.

The investment decision problem for f‌irms can be

modeled as a present value problem, where the present

value of future cash f‌lows are discounted using the

weighted average cost of capital. The weighted average cost

of capital is a combination of internal and external costs of

f‌inancing. The cost of external f‌inancing can be modeled as

an increasing function of four variables – the external f‌inanc-

ing risk, the f‌inancing constraint and f‌inancial non-

development, the scarcity of insider ownership, and the

def‌iciency of monitoring mechanisms and legal environ-

ment. As any of the variables increase in magnitude, it

becomes more diff‌icult for f‌irms to f‌inance investments

externally, and internal f‌inancing becomes either the major

or the only source of f‌inancing capital investment.

The future cash f‌lows also depend on a quality function,

which coalesces as four quality dimensions – managerial

quality, the corporate governance mechanism, shareholder

protection, and the level of f‌inancial development. The

quality function is higher if managers are more talented,

there are well-established corporate governance mecha-

nisms, there are good shareholder protection laws, or the

f‌inancial markets are well developed.A high quality implies

that managers will choose, or will be forced to make, good

capital investment decisions, which will lead to high future

cash f‌lows and earnings.

We examine the dynamic causal relationship between

earnings and capital investment with testable hypotheses

based on the choice between external and internal f‌inancing

alternatives and on the quality function determined by the

ability of managers, maturity of f‌inancial markets, and the

legal system. Further, we examine the inf‌luence of business

cycles and insider ownership in f‌irms on the dynamic causal

relation.

From Earnings to Capital Investment

First, we hypothesize that the causal relationship of earnings

to capital investment will be greater for f‌irms in weak cor-

porate governance countries than for f‌irms in strong corpo-

rate governance countries. According to the free cash f‌low

hypothesis of Jensen (1986), managers have incentives to

grow their f‌irms beyond optimal size because growth

increases the amount of resources under their control. In

weak corporate governance environments, f‌irms with large

earnings are more likely to engage in many investment

projects that benef‌it managers privately but that are not in

shareholders’ best interests.2Thus, in weak corporate gover-

nance environments, capital investment will display rela-

tively high sensitivities to earnings. This corresponds to a

higher def‌iciency in monitoring and higher external f‌inanc-

ing costs and makes internal f‌inancing more attractive. The

legal system of a country can also affect the relationship.

Cuervo (2002) compares common law and civil law coun-

tries and f‌inds that corporate governance rules are better

enforced in common law countries. Li and Filer (2007) study

the mode of investment and the governance environment

and f‌ind that in countries with a poor rule of law, investors

prefer foreign direct investment to indirect (portfolio)

investment. Therefore, their study also implies that the

earnings-capital investment relationship is positive and

stronger in countries with weak legal protections.

Second, we hypothesize that the causal relationship of

earnings to capital investment will be relatively high for

f‌irms that operate in countries without f‌inancially developed

markets. This hypothesis is relatedto the f‌inancial constraint

literature. Based on the pecking order theory, Fazzari,

Hubbard, and Petersen (1988) argue that capital investment

is more sensitive to internal funds, such as earnings, if the

f‌irms are f‌inancially constrained. Many empirical studies

tend to use the sensitivity of capital investment to the avail-

CAPITAL INVESTMENT AND EARNINGS 527

Volume 17 Number 5 September 2009© 2009 Blackwell Publishing Ltd