Impact of investment efficiency on cost of equity: evidence from China
| Published date | 02 January 2018 |
| DOI | https://doi.org/10.1108/JABS-09-2015-0163 |
| Pages | 44-59 |
| Date | 02 January 2018 |
| Author | Muhammad Ansar Majeed,Xianzhi Zhang,Muhammad Umar |
| Subject Matter | Strategy,International business |
Impact of investment efficiency on cost of
equity: evidence from China
Muhammad Ansar Majeed, Xianzhi Zhang and Muhammad Umar
Muhammad Ansar
Majeed is based at the
International Business
School, Zhejiang
Gongshang University,
Hangzhou, China.
Xianzhi Zhang is based
at the School of
Accounting, Dongbei
University of Finance and
Economics, Dalian,
China. Muhammad Umar
is based at AIR
University, Islamabad,
Pakistan.
Abstract
Purpose –The purpose of this study is to investigate the effect of investment efficiency on cost of equity
capital.
Design/methodology/approach –Prior research indicated that any governance mechanism which
reduces the agency conflict reduces the cost of equity capital. This study provides empirical evidence
that investment efficiency represents such governance mechanism which reduces agency conflict and
hence cost of equity. The authors use price earning growth ratio (Easton, 2004) and Ohlson and
Juettner-Nauroth (2005) model for the measurement of cost of equity while investment efficiency
measure of Biddle et al. (2009) have been employed to examine the association. We also use Chen et
al. (2013) measure of investment efficiency for robustness.
Findings –The results show that investment efficiency is negatively associated with cost of equity. It
was also found that there is a strong relationship of investment efficiency with cost of equity for
non-state-owned enterprises (NSOEs), while no significant relationship is found for state-owned
enterprises. Furthermore, overinvestment is significantly associated with cost of equity capital.
However, no significant relationship was found between underinvestment and cost of equity.
Originality/value –The results provide empirical support to the argument that investment efficiency acts
as a mechanism which represents lower agency conflict. Moreover, the findings provide evidence that
government act as “deep pocket” while NSOEs are punished by investors for inefficient resource allocation.
This study also proposes that there is a positive relationship between overinvestment and cost of equity.
Keywords Overinvestment, Underinvestment, Cost of equity, Investment efficiency
Paper type Research paper
1. Introduction
Separation of ownership from management results in agency risk which arises due to the moral
hazards and adverse selection (Jensen and Meckling, 1976). Firms employ various
governance mechanisms to protect the shareholders from the opportunistic behavior of the
managers and in certain cases majority shareholders. There is abundant prior literature which
suggests that any governance mechanism that reduces the agency risk and informational risk
can reduce the cost of equity (CoE) capital and vice versa (Huang et al., 2009;Chen et al.,
2009,2011). Hence, the CoE may be reduced in the presence of higher quality governance
mechanisms as such mechanisms reduce the opportunistic behavior of the management.
Lambert et al. (2007) suggested another approach which may reduce the cost of capital.
According to them, accounting information disclosure quality affects the cost of capital through
two different channels. First, quality of disclosure reduces information asymmetry between
management and outside investors. Second, disclosure quality influences the real managerial
decisions (like production and investment) as well which in turn have an effect on future cash
flows and, hence, ultimately affect the cost of capital.
Preceding literature (Biddle et al., 2009;Chen et al., 2011;Cheng et al., 2013;Cutillas
Gomariz and Sánchez Ballesta, 2014) also suggests that investment efficiency (IE) is
associated with lower information asymmetry which in turn leads toward lower level of moral
Received 11 September 2015
Revised 5 February 2016
25 April 2016
29 May 2016
Accepted 4 June 2016
PAGE 44 JOURNAL OF ASIA BUSINESS STUDIES VOL. 12 NO. 1, 2018, pp. 44-59, © Emerald Publishing Limited, ISSN 1558-7894 DOI 10.1108/JABS-09-2015-0163
hazards and adverse selection problem. Biddle et al. (2009) suggested that firms with
higher financial reporting quality are associated with lower level of underinvestment and
(or) overinvestment. They further argued that firms with higher financial reporting quality do
not deviate from predicted investment level. They also found that a firm’s deviation from
predicted level is less sensitive to macro-economic conditions if it has higher financial
reporting quality. Biddle et al. (2009) argued that the reason behind this association
between financial reporting quality and IE is lower information asymmetry and reduced
agency risk because of fewer incentives for managerial opportunism in the presence of
higher reporting quality. Similarly, Chen et al. (2011) argued that financial reporting quality
reduces agency cost by improving IE in private firms, and Cutillas Gomariz and Sánchez
Ballesta (2014) proposed that not only financial reporting quality but debt maturity also
plays an important role in controlling managerial opportunism and hence improves IE.
These arguments suggest that any mechanism which reduces managerial opportunism
(agency risk) and informational risk would reduce inefficient investment. These studies also
suggest that there is lower agency risk and lower information asymmetry when IE is higher. This
implies that the firms with higher level of IE would have lower agency problems caused by
opportunistic behavior of the management. Based on this discussion, two viewpoints can be
extracted. First, IE is associated with lower information asymmetry and lower agency risk.
Second, lower informational risk and agency conflict can reduce CoE. This study links these
two viewpoints and examines whether IE leads to lower CoE. This study seeks to answer the
question: Is there a link between IE and CoE capital? Or, does IE which is a result of lower level
of agency conflict leads to lower CoE? What is the impact of state ownership on the relationship
between IE and CoE? What is the effect of overinvestment (underinvestment) on the CoE?
IE is an important concept in this study. In perfect financial markets, firms invest efficiently
if they carry out all the projects with positive net present value (NPV) and reject those with
negative NPV. However, prior literature (Hubbard, 1998;Bertrand and Mullainathan, 2003)
refutes this assumption, as the world is not without frictions. Hence, the market
imperfections along with information asymmetries and agency conflicts can potentially lead
to accepting the projects with negative NPV (overinvestment) and rejection of projects with
positive NPV (underinvestment). Following earlier literature (e.g. Biddle et al., 2009;Chen
et al., 2011;Cheng et al., 2013), IE is defined as expected level of investment which is
measured as predicted investment level based on sales growth opportunities. A positive
deviation from expected level (i.e. investment higher than predicted level) is considered as
overinvestment, and negative deviation from expected level (i.e. investment lower than
predicted level) is regarded as underinvestment, while both (i.e. overinvestment and
underinvestment) constitute inefficient investment.
This study is based on the sample of A-listed Chinese firms for the period spanning
2000-2013. We document that IE is negatively associated with CoE. Notably, the results
show that higher IE leads toward lower CoE, which suggests that investors take into
account the investment decisions made by the firms and also confirms the proposition of
Lambert et al. (2007) that decisions like investment influence the cost of capital. We further
extend our analysis by examining the impact of IE on CoE for state-owned enterprises
(SOEs) and non-state-owned enterprises (NSOEs). Chinese institutional environment offers
a unique research opportunity because of large number of SOEs. SOEs and NSOEs differ
in the nature of their ownership structure, agency conflict and bankruptcy risk. The main
objective of SOEs is not profit maximization but they pursue other social objectives like
employment of the region and political objectives of the state which makes them quite
different from NSOEs. In case these SOEs face financial distress, they are bailed out by the
government (Faccio, 2006). This study hypothesizes and documents that effect of IE on
CoE capital is only pronounced for NSOEs, while we do not find any statistically significant
between IE and CoE for SOEs. This association is expected because of lower risk
associated with SOEs as argued by Chen et al. (2010) and potential support from the state
VOL. 12 NO. 1 2018 JOURNAL OF ASIA BUSINESS STUDIES PAGE 45
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