How do Agency Problems Affect the Implied Cost of Capital?
DOI:
https://doi.org/10.6000/1929-7092.2016.05.18Keywords:
, Agency problems, Free cash flows, Overinvestment, Implied cost of capitalAbstract
We test the relationship between the implied cost of capital and two agency problems, free cash flows and overinvestment. We show that free cash flows have a significant negative impact on the implied cost of capital, but overinvestment has a significantly positive impact. In addition, the pay-for-performance sensitivity has a negative effect but the sensitivity of volatility has a significantly positive effect on the implied cost of capital. After taking the incentives into account, we find that the significance of the impact from both agency problems still exists. Finally, we conclude that well-designed executive compensation should focus on reducing overinvestment and the sensitivity of volatility.
References
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http://dx.doi.org/10.1016/j.jcorpfin.2006.01.001
Albuquerque, R., and N. Wang, 2008. Agency conflicts, investment, and asset pricing. Journal of Finance 63, 1-40.
http://dx.doi.org/10.1111/j.1540-6261.2008.01309.x
Ali, A., L.-S. Hwang and M. A. Trombley, 2003. Residual-income-based valuation predicts future stock returns: Evidence on mispricing vs. risk explanations. The Accounting Review 78, 377-396.
http://dx.doi.org/10.2308/accr.2003.78.2.377
Almeida, H., M. Campello, and M. S. Weisbach, 2004. The cash flow sensitivity of cash. The Journal of Finance 59, 1777-1804.
http://dx.doi.org/10.1111/j.1540-6261.2004.00679.x
Baker, G. P., and B. J. Hall, 2004. CEO incentives and firm size. Journal of Labor Economics 22, 767-798.
http://dx.doi.org/10.1086/423154
Barron, O. E., D. Byard, C. Kile and E. J. Riedl, 2002. High-technology intangibles and analysts' forecasts. Journal of Accounting Research 40, 289-312.
http://dx.doi.org/10.1111/1475-679X.00048
Bizjak, J. M., J. A. Brickley, and J. L. Coles, 1993. Stock-based incentive compensation and investment behavior. Journal of Accounting and Economics 16, 349-372.
http://dx.doi.org/10.1016/0165-4101(93)90017-A
Botosan, C. A., and M. A. Plumlee, 2005. Assessing alternative proxies for the expected risk premium. Accounting Review 80, 21-53.
http://dx.doi.org/10.2308/accr.2005.80.1.21
Broussard, J. P., S. A. Buchenroth, and E. A. Pilotte, 2004. CEO incentives, cash flow, and investment. Financial Management 33, 51-70.
Byun, H.-Y., S.-K. Kwak, and L.-S. Hwang, 2008. The implied cost of equity capital and corporate governance practices. Asia-Pacific Journal of Financial Studies 37, 139-184.
Cai, J., and A. M. Vijh, 2007. Incentive effects of stock and option holdings of target and acquirer CEOs. The Journal of Finance 62, 1891-1933.
http://dx.doi.org/10.1111/j.1540-6261.2007.01260.x
Chen, K. C. W, Z. Chen, and K. C. J. Wei, 2011. Agency costs of free cash flow and the effect of shareholder rights on the implied cost of equity capital. Journal of Financial and Quantitative Analysis 46, 171-207.
http://dx.doi.org/10.1017/S0022109010000591
Claus, J. and J. Thomas, 2001. Equity premia as low as three percent? Evidence from analysts' earnings forecasts for domestic and international stock markets. The Journal of Finance 56, 1629-1666.
http://dx.doi.org/10.1111/0022-1082.00384
Core, J. E., and D. F. Larcker, 2002. Performance consequences of mandatory increases in executive stock ownership. Journal of Financial Economics 64, 317-340.
http://dx.doi.org/10.1016/S0304-405X(02)00127-7
Core, J.E., Guay, W., 2002. Estimating the value of employee stock option portfolios and their sensitivities to price and volatility. Journal of Accounting Research 40, 613-630.
http://dx.doi.org/10.1111/1475-679X.00064
Core, J. E., W. Guay, and D. F. Larcker, 2003. Executive equity compensation and incentives: A survey. Economic Policy Review 9, 27-50.
Dechow, P. M., A. P. Hutton, and R. G. Sloan, 1999. An empirical assessment of the residual income valuation model. Journal of Accounting and Economics 26, 1-34.
http://dx.doi.org/10.1016/S0165-4101(98)00049-4
Easton, P. D., 2004. PE ratios, PEG ratios, and estimating the implied expected rate of return on equity capital. The Accounting Review 79, 73-95.
http://dx.doi.org/10.2308/accr.2004.79.1.73
Easton, P. D., and S. J. Monahan, 2005. An evaluation of accounting-based measures of expected returns. Accounting Review 80, 501-538.
http://dx.doi.org/10.2308/accr.2005.80.2.501
Garmaise, M. J., and J. Liu, 2005. Corruption, firm governance, and the cost of capital. Working Paper, UCLA.
Gebhardt, W. R., C. M. C. Lee, and B. Swaminathan, 2001. Toward an implied cost of capital. Journal of Accounting Research 39, 135-176.
http://dx.doi.org/10.1111/1475-679X.00007
Gode, D., and P. Mohanram, 2003. Inferring the cost of capital using the Ohlson-Juettner model. Review of Accounting Studies 8, 399-431.
http://dx.doi.org/10.1023/A:1027378728141
Guay, W., 1999. The sensitivity of CEO wealth to equity risk: An analysis of the magnitude and determinants. Journal of Financial Economics 53, 43-71.
http://dx.doi.org/10.1016/S0304-405X(99)00016-1
Hail, L., and C. Leuz, 2006. International differences in the cost of equity capital: Do legal institutions and securities regulation matter? Journal of Accounting Research 44, 485-531.
http://dx.doi.org/10.1111/j.1475-679X.2006.00209.x
Hail, L., and C. Leuz, 2009. Cost of capital effects and changes in growth expectations around U.S. cross-listings. Journal of Financial Economics 93, 428-454.
http://dx.doi.org/10.1016/j.jfineco.2008.09.006
Hall, B. J., and K. J. Murphy, 2002. Stock options for undiversified executive. Journal of Accounting and Economics 33, 3-42.
http://dx.doi.org/10.1016/S0165-4101(01)00050-7
Hall, B. J., and J. Liebman, 1998. Are CEOs really paid like bureaucrats? Quarterly Journal of Economics 103, 653-691.
http://dx.doi.org/10.1162/003355398555702
Hall, B. J. and T. A. Knox, 2004. Underwater options and the dynamics of executive pay-to-performance sensitivities. Journal of Accounting Research 42, 365-412.
http://dx.doi.org/10.1111/j.1475-679X.2004.00142.x
Harford, J., 1999. Corporate cash reserves and acquisitions. The Journal of Finance 54, 1969-1997.
http://dx.doi.org/10.1111/0022-1082.00179
Jensen, M. C., 1986. Agency cost of free cash flow, corporate finance and takeovers. The American Economic Review 76, 323-329.
Jensen, M. C., and K. J. Murphy, 1990. Performance pay and top-management incentives. Journal of Political Economy 98, 225-264.
http://dx.doi.org/10.1086/261677
Jensen, M. C., and W. Meckling, 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3, 305-360.
http://dx.doi.org/10.1016/0304-405X(76)90026-X
Kalcheva, I., and K. V. Lins, 2007. International evidence on cash holdings and expected managerial agency problems. The Review of Financial Studies 20, 1087-1112.
http://dx.doi.org/10.1093/rfs/hhm023
Lang, L., and R. Litzenberger, 1989. Dividend announcements: cash flow signaling vs. free cash flow hypothesis? Journal of Financial Economics 24, 181-191.
http://dx.doi.org/10.1016/0304-405X(89)90077-9
Li, X., 2015. Accounting conservatism and the cost of capital: An international analysis. Journal of Business Finance & Accounting 42, 555-582.
http://dx.doi.org/10.1111/jbfa.12121
McConnell, J. J., and H. Servaes, 1990. Additional evidence on equity ownership and corporate value. Journal of Financial Economics 27, 595-612.
http://dx.doi.org/10.1016/0304-405X(90)90069-C
Mehran, H., 1995. Executive compensation structure, ownership, and firm performance. Journal of Financial Economics 38, 163-184.
http://dx.doi.org/10.1016/0304-405X(94)00809-F
Mikkelson, W. H., and M. M. Partch, 2003. Do persistent large cash reserves hinder performance? Journal of Financial Quantitative Analysis 38, 275-294.
http://dx.doi.org/10.2307/4126751
Morck, R., A. Shleifer, and R. W. Vishny, 1988. Management ownership and market valuation - An empirical analysis. Journal of Financial Economics 20, 293-315.
http://dx.doi.org/10.1016/0304-405X(88)90048-7
Myers, S. C., 1984. The capital structure puzzle. The Journal of Finance 56, 575-592.
http://dx.doi.org/10.2307/2327916
Myers, S. C., and N. S. Majluf, 1984. Corporate financing and investment decisions when firms have information the investors do not have. Journal of Financial Economics 13, 187-221.
http://dx.doi.org/10.1016/0304-405X(84)90023-0
Myers, S. C., and R. G. Rajan, 1998. The paradox of liquidity. Quarterly Journal of Economics 108, 733-771.
http://dx.doi.org/10.1162/003355398555739
Officer, M. S., 2011. Overinvestment, corporate governance, and dividend initiations. Journal of Corporate Finance 17, 710-724.
http://dx.doi.org/10.1016/j.jcorpfin.2010.06.004
Ohlson, J. A., B.E. Juettner-Nauroth, 2005. Expected EPS and EPS growth as determinants of value. Review of Accounting Studies 10, 349-365.
http://dx.doi.org/10.1007/s11142-005-1535-3
Richardson, Scott, 2006. Over-investment of free cash flow. Review of Accounting Studies 11, 159-189.
http://dx.doi.org/10.1007/s11142-006-9012-1
Stulz, R. M., 1995. Does the cost of capital differ across countries? An agency perspective. European Financial Management 2, 11-22.
http://dx.doi.org/10.1111/j.1468-036X.1996.tb00026.x
Stulz, R. M., 1999. Globalization, Corporate Finance and the Cost of Capital. Journal of Applied Corporate Finance 12, 8-25.
http://dx.doi.org/10.1111/j.1745-6622.1999.tb00027.x
Yermack, D., 1995. Do corporations award CEO stock options effectively? Journal of Financial Economics 39, 237-269.
http://dx.doi.org/10.1016/0304-405X(95)00829-4
http://dx.doi.org/10.1016/j.jcorpfin.2006.01.001
Albuquerque, R., and N. Wang, 2008. Agency conflicts, investment, and asset pricing. Journal of Finance 63, 1-40.
http://dx.doi.org/10.1111/j.1540-6261.2008.01309.x
Ali, A., L.-S. Hwang and M. A. Trombley, 2003. Residual-income-based valuation predicts future stock returns: Evidence on mispricing vs. risk explanations. The Accounting Review 78, 377-396.
http://dx.doi.org/10.2308/accr.2003.78.2.377
Almeida, H., M. Campello, and M. S. Weisbach, 2004. The cash flow sensitivity of cash. The Journal of Finance 59, 1777-1804.
http://dx.doi.org/10.1111/j.1540-6261.2004.00679.x
Baker, G. P., and B. J. Hall, 2004. CEO incentives and firm size. Journal of Labor Economics 22, 767-798.
http://dx.doi.org/10.1086/423154
Barron, O. E., D. Byard, C. Kile and E. J. Riedl, 2002. High-technology intangibles and analysts' forecasts. Journal of Accounting Research 40, 289-312.
http://dx.doi.org/10.1111/1475-679X.00048
Bizjak, J. M., J. A. Brickley, and J. L. Coles, 1993. Stock-based incentive compensation and investment behavior. Journal of Accounting and Economics 16, 349-372.
http://dx.doi.org/10.1016/0165-4101(93)90017-A
Botosan, C. A., and M. A. Plumlee, 2005. Assessing alternative proxies for the expected risk premium. Accounting Review 80, 21-53.
http://dx.doi.org/10.2308/accr.2005.80.1.21
Broussard, J. P., S. A. Buchenroth, and E. A. Pilotte, 2004. CEO incentives, cash flow, and investment. Financial Management 33, 51-70.
Byun, H.-Y., S.-K. Kwak, and L.-S. Hwang, 2008. The implied cost of equity capital and corporate governance practices. Asia-Pacific Journal of Financial Studies 37, 139-184.
Cai, J., and A. M. Vijh, 2007. Incentive effects of stock and option holdings of target and acquirer CEOs. The Journal of Finance 62, 1891-1933.
http://dx.doi.org/10.1111/j.1540-6261.2007.01260.x
Chen, K. C. W, Z. Chen, and K. C. J. Wei, 2011. Agency costs of free cash flow and the effect of shareholder rights on the implied cost of equity capital. Journal of Financial and Quantitative Analysis 46, 171-207.
http://dx.doi.org/10.1017/S0022109010000591
Claus, J. and J. Thomas, 2001. Equity premia as low as three percent? Evidence from analysts' earnings forecasts for domestic and international stock markets. The Journal of Finance 56, 1629-1666.
http://dx.doi.org/10.1111/0022-1082.00384
Core, J. E., and D. F. Larcker, 2002. Performance consequences of mandatory increases in executive stock ownership. Journal of Financial Economics 64, 317-340.
http://dx.doi.org/10.1016/S0304-405X(02)00127-7
Core, J.E., Guay, W., 2002. Estimating the value of employee stock option portfolios and their sensitivities to price and volatility. Journal of Accounting Research 40, 613-630.
http://dx.doi.org/10.1111/1475-679X.00064
Core, J. E., W. Guay, and D. F. Larcker, 2003. Executive equity compensation and incentives: A survey. Economic Policy Review 9, 27-50.
Dechow, P. M., A. P. Hutton, and R. G. Sloan, 1999. An empirical assessment of the residual income valuation model. Journal of Accounting and Economics 26, 1-34.
http://dx.doi.org/10.1016/S0165-4101(98)00049-4
Easton, P. D., 2004. PE ratios, PEG ratios, and estimating the implied expected rate of return on equity capital. The Accounting Review 79, 73-95.
http://dx.doi.org/10.2308/accr.2004.79.1.73
Easton, P. D., and S. J. Monahan, 2005. An evaluation of accounting-based measures of expected returns. Accounting Review 80, 501-538.
http://dx.doi.org/10.2308/accr.2005.80.2.501
Garmaise, M. J., and J. Liu, 2005. Corruption, firm governance, and the cost of capital. Working Paper, UCLA.
Gebhardt, W. R., C. M. C. Lee, and B. Swaminathan, 2001. Toward an implied cost of capital. Journal of Accounting Research 39, 135-176.
http://dx.doi.org/10.1111/1475-679X.00007
Gode, D., and P. Mohanram, 2003. Inferring the cost of capital using the Ohlson-Juettner model. Review of Accounting Studies 8, 399-431.
http://dx.doi.org/10.1023/A:1027378728141
Guay, W., 1999. The sensitivity of CEO wealth to equity risk: An analysis of the magnitude and determinants. Journal of Financial Economics 53, 43-71.
http://dx.doi.org/10.1016/S0304-405X(99)00016-1
Hail, L., and C. Leuz, 2006. International differences in the cost of equity capital: Do legal institutions and securities regulation matter? Journal of Accounting Research 44, 485-531.
http://dx.doi.org/10.1111/j.1475-679X.2006.00209.x
Hail, L., and C. Leuz, 2009. Cost of capital effects and changes in growth expectations around U.S. cross-listings. Journal of Financial Economics 93, 428-454.
http://dx.doi.org/10.1016/j.jfineco.2008.09.006
Hall, B. J., and K. J. Murphy, 2002. Stock options for undiversified executive. Journal of Accounting and Economics 33, 3-42.
http://dx.doi.org/10.1016/S0165-4101(01)00050-7
Hall, B. J., and J. Liebman, 1998. Are CEOs really paid like bureaucrats? Quarterly Journal of Economics 103, 653-691.
http://dx.doi.org/10.1162/003355398555702
Hall, B. J. and T. A. Knox, 2004. Underwater options and the dynamics of executive pay-to-performance sensitivities. Journal of Accounting Research 42, 365-412.
http://dx.doi.org/10.1111/j.1475-679X.2004.00142.x
Harford, J., 1999. Corporate cash reserves and acquisitions. The Journal of Finance 54, 1969-1997.
http://dx.doi.org/10.1111/0022-1082.00179
Jensen, M. C., 1986. Agency cost of free cash flow, corporate finance and takeovers. The American Economic Review 76, 323-329.
Jensen, M. C., and K. J. Murphy, 1990. Performance pay and top-management incentives. Journal of Political Economy 98, 225-264.
http://dx.doi.org/10.1086/261677
Jensen, M. C., and W. Meckling, 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3, 305-360.
http://dx.doi.org/10.1016/0304-405X(76)90026-X
Kalcheva, I., and K. V. Lins, 2007. International evidence on cash holdings and expected managerial agency problems. The Review of Financial Studies 20, 1087-1112.
http://dx.doi.org/10.1093/rfs/hhm023
Lang, L., and R. Litzenberger, 1989. Dividend announcements: cash flow signaling vs. free cash flow hypothesis? Journal of Financial Economics 24, 181-191.
http://dx.doi.org/10.1016/0304-405X(89)90077-9
Li, X., 2015. Accounting conservatism and the cost of capital: An international analysis. Journal of Business Finance & Accounting 42, 555-582.
http://dx.doi.org/10.1111/jbfa.12121
McConnell, J. J., and H. Servaes, 1990. Additional evidence on equity ownership and corporate value. Journal of Financial Economics 27, 595-612.
http://dx.doi.org/10.1016/0304-405X(90)90069-C
Mehran, H., 1995. Executive compensation structure, ownership, and firm performance. Journal of Financial Economics 38, 163-184.
http://dx.doi.org/10.1016/0304-405X(94)00809-F
Mikkelson, W. H., and M. M. Partch, 2003. Do persistent large cash reserves hinder performance? Journal of Financial Quantitative Analysis 38, 275-294.
http://dx.doi.org/10.2307/4126751
Morck, R., A. Shleifer, and R. W. Vishny, 1988. Management ownership and market valuation - An empirical analysis. Journal of Financial Economics 20, 293-315.
http://dx.doi.org/10.1016/0304-405X(88)90048-7
Myers, S. C., 1984. The capital structure puzzle. The Journal of Finance 56, 575-592.
http://dx.doi.org/10.2307/2327916
Myers, S. C., and N. S. Majluf, 1984. Corporate financing and investment decisions when firms have information the investors do not have. Journal of Financial Economics 13, 187-221.
http://dx.doi.org/10.1016/0304-405X(84)90023-0
Myers, S. C., and R. G. Rajan, 1998. The paradox of liquidity. Quarterly Journal of Economics 108, 733-771.
http://dx.doi.org/10.1162/003355398555739
Officer, M. S., 2011. Overinvestment, corporate governance, and dividend initiations. Journal of Corporate Finance 17, 710-724.
http://dx.doi.org/10.1016/j.jcorpfin.2010.06.004
Ohlson, J. A., B.E. Juettner-Nauroth, 2005. Expected EPS and EPS growth as determinants of value. Review of Accounting Studies 10, 349-365.
http://dx.doi.org/10.1007/s11142-005-1535-3
Richardson, Scott, 2006. Over-investment of free cash flow. Review of Accounting Studies 11, 159-189.
http://dx.doi.org/10.1007/s11142-006-9012-1
Stulz, R. M., 1995. Does the cost of capital differ across countries? An agency perspective. European Financial Management 2, 11-22.
http://dx.doi.org/10.1111/j.1468-036X.1996.tb00026.x
Stulz, R. M., 1999. Globalization, Corporate Finance and the Cost of Capital. Journal of Applied Corporate Finance 12, 8-25.
http://dx.doi.org/10.1111/j.1745-6622.1999.tb00027.x
Yermack, D., 1995. Do corporations award CEO stock options effectively? Journal of Financial Economics 39, 237-269.
http://dx.doi.org/10.1016/0304-405X(95)00829-4
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Published
2016-06-01
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Wu, C.-C., Lin, B.-H., & Yang, T.-H. (2016). How do Agency Problems Affect the Implied Cost of Capital?. Journal of Reviews on Global Economics, 5, 210–226. https://doi.org/10.6000/1929-7092.2016.05.18
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