chirinko_02

Emory University
Department of Economics
Working Papers

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

Number: 02-10

Author: Robert S.Chirinko , Huntley Schaller

Issue Date: November 2002

Abstract: This paper sheds new light on long-standing corporate governance problems. Governance problems have a direct and immediate impact on the effective discount rate guiding investment decisions. By studying the gap between the discount rates used by executives and shareholders, we assess the extent to which governance problems distort firm behavior. The estimation strategy recovers discount rates used by executives from the pattern of their actual investment spending. Information from a transformed net present value rule and variation in firm-level panel data “reveal” the effective discount rate guiding investment decisions. 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), investment behavior appears to be guided by discount rates that are less than the market rate by 350-400 basis points, thus supporting the Free Cash Flow view that unresolved corporate governance problems distort firm behavior. This wedge is reduced for firms with a concentrated ownership structure. Firms in our sample that face Free Cash Flow problems have a stock of fixed capital that is approximately 7% to 22% higher than would prevail under value maximizing behavior.

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Title:	A Revealed Preference Approach To Understanding Corporate Governance Problems: Evidence From Canada
Number:	02-10
Author:	Robert S.Chirinko , Huntley Schaller
Issue Date:	November 2002
Abstract:	This paper sheds new light on long-standing corporate governance problems. Governance problems have a direct and immediate impact on the effective discount rate guiding investment decisions. By studying the gap between the discount rates used by executives and shareholders, we assess the extent to which governance problems distort firm behavior. The estimation strategy recovers discount rates used by executives from the pattern of their actual investment spending. Information from a transformed net present value rule and variation in firm-level panel data “reveal” the effective discount rate guiding investment decisions. 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), investment behavior appears to be guided by discount rates that are less than the market rate by 350-400 basis points, thus supporting the Free Cash Flow view that unresolved corporate governance problems distort firm behavior. This wedge is reduced for firms with a concentrated ownership structure. Firms in our sample that face Free Cash Flow problems have a stock of fixed capital that is approximately 7% to 22% higher than would prevail under value maximizing behavior.