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The The Impact of Investment Opportunities and Impact of Investment Opportunities and Free Cash Flow on Financial Liberalization: Free Cash Flow on Financial Liberalization:

A Cross-Firm Analysis of Emerging EconomiesA Cross-Firm Analysis of Emerging Economies

Sheng-Syan ChenSheng-Syan Chen

Robin K. ChouRobin K. Chou

Shu-Fen ChouShu-Fen Chou

(Financial Management, 2009, Forthcoming)(Financial Management, 2009, Forthcoming)

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MotivationMotivation

• A growing body of empirical research examines the A growing body of empirical research examines the effects of capital account liberalization on equity prices effects of capital account liberalization on equity prices (Bekaert & Harvey, 1998; Henry, 2000a; Kim & (Bekaert & Harvey, 1998; Henry, 2000a; Kim & Singal, 2000), liquidity (Levine & Zervos, 1998a), Singal, 2000), liquidity (Levine & Zervos, 1998a), private investment (Bekaert & Harvey, 1998 & 2000; private investment (Bekaert & Harvey, 1998 & 2000; Levine & Zervos, 1998b; Henry, 2000b), equity flows Levine & Zervos, 1998b; Henry, 2000b), equity flows (Bekaert et al., 2002), and economic growth (Bekaert (Bekaert et al., 2002), and economic growth (Bekaert et al., 2001 & 2005). et al., 2001 & 2005).

Capital account liberalization leads to higher equity Capital account liberalization leads to higher equity prices, lower capital costs, private investment booms, prices, lower capital costs, private investment booms, greater capital flows, and higher economic growth. greater capital flows, and higher economic growth.

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• The vast majority of the prior studies have tended to The vast majority of the prior studies have tended to analyze the effects of stock market liberalization analyze the effects of stock market liberalization through an examination of aggregate stock market through an examination of aggregate stock market indices, with the presentation of empirical evidence at indices, with the presentation of empirical evidence at firm level remaining quite sparse. firm level remaining quite sparse.

As suggested by Martell & Stulz (2003), stock market As suggested by Martell & Stulz (2003), stock market liberalization increases the pool of investors who are liberalization increases the pool of investors who are able to invest in firms. able to invest in firms.

However, the extent to which a country actually benefits However, the extent to which a country actually benefits from stock market liberalization is largely dependent on from stock market liberalization is largely dependent on the extent to which firms can take advantage of it. the extent to which firms can take advantage of it.

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• More importantly, stock market liberalization does not More importantly, stock market liberalization does not necessarily benefit shareholders. necessarily benefit shareholders.

It may in fact have a negative economic impact on firms It may in fact have a negative economic impact on firms if the costs of liberalization outweigh the benefits. if the costs of liberalization outweigh the benefits.

A firm-level analysis thus provides us with important A firm-level analysis thus provides us with important information that might enable us to assess the impact of information that might enable us to assess the impact of capital account liberalization and the channels through capital account liberalization and the channels through which such liberalization affects firms. which such liberalization affects firms.

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This PaperThis Paper

• Purpose:

This study investigates the role of investment opportunities and free cash flow in explaining the value-enhancing potential of stock market liberalization at firm level.

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The investment opportunities hypothesis:

As argued by Henry (2000b) & Bekaert et al. (2001), stock market liberalization expands a firm’s investment opportunity set and stimulates its investment as a direct result of the falling cost of equity capital following liberalization.

The value-enhancing potential of investment depends on the availability, or lack, of investment opportunities (Lang et al., 1989 & 1991; Doukas, 1995; Brailsford & Yeoh, 2004).

Specifically, for firms with good investment opportunities, corporate investment is generally regarded as worthwhile, whereas such investment by firms with poor opportunities is not.

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The investment opportunities hypothesis:

This suggests that stock market liberalization creates greater value for firms with high growth opportunities, and less value for firms with low investment opportunities.

Martell & Stulz (2003) also argue that stock market liberalization is more beneficial to high-growth firms because the local market may not provide sufficient funding to meet their capital needs.

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The free cash flow hypothesis:

While stock market liberalization results in a reduction in the cost of equity capital, it may also create incentives for overinvestment.

Berkovitch & Kim (1990) suggest that the lower cost of capital will create incentives for firms to engage in excessive investment, which may take the form of accepting negative NPV projects.

Such potential for overinvestment is expected to be more serious for firms characterized by high free cash flow.

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The free cash flow hypothesis:

The free cash flow theory of Jensen (1986) argues that potential agency conflicts arise when managers have control of cash flows in excess of those necessary for profitable investment.

Such agency costs come as a result of managers’ using their excess cash flow to overinvest in the firm, so that shareholder wealth is not maximized.

Thus, if Jensen’s theory holds, we expect that the value of stock market liberalization will have an inverse relationship with the existing level of free cash flow within a firm because the potential agency costs are higher for firms with high cash flow.

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The corporate governance hypothesis:

There is an alternative hypothesis which predicts that stock market liberalization may create greater value for firms with high cash flow than for those with low cash flow.

Stulz (1999) and Martel & Stulz (2003) note that stock market liberalization reduces the cost of capital, not only by sharing risk, but also by improving corporate governance.

The introduction of foreign investors increases monitoring intensity, thereby reducing the agency costs of free cash flow.

This implies that following liberalization, firms that are prone to agency problems, such as those with high free cash flow, are more likely to experience greater increases in equity value.

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Sample Sample and Descriptive Statisticsand Descriptive Statistics

• Stock Market Liberalization DatesStock Market Liberalization Dates

One form of stock market liberalization is the removal of One form of stock market liberalization is the removal of barriers to direct investment in some, or all, classes of shares barriers to direct investment in some, or all, classes of shares in an emerging stock market. in an emerging stock market.

ADRs and country funds represent two additional forms of ADRs and country funds represent two additional forms of stock market liberalization that allow stocks to be traded in stock market liberalization that allow stocks to be traded in the developed markets and that have the potential of more the developed markets and that have the potential of more effectively reducing barriers to liquidity and information. effectively reducing barriers to liquidity and information.

Most of the prior studies have focused on the effects of the Most of the prior studies have focused on the effects of the first liberalization events, irrespective of the various forms first liberalization events, irrespective of the various forms of liberalization. of liberalization.

In this study, we examine all three main types of stock In this study, we examine all three main types of stock market liberalization.market liberalization.

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• Data and Variable DescriptionsData and Variable Descriptions::

We obtain data on stock returns and firm characteristics We obtain data on stock returns and firm characteristics from the Pacific-Basin Capital Markets (PACAP) database from the Pacific-Basin Capital Markets (PACAP) database for firms in five East Asian countries: Indonesia, Malaysia, for firms in five East Asian countries: Indonesia, Malaysia, South Korea, Taiwan, and Thailand. South Korea, Taiwan, and Thailand.

The data on firms in the remaining nine countries are The data on firms in the remaining nine countries are obtained from Datastream and Worldscope. obtained from Datastream and Worldscope.

We use daily stock returns to examine the announcement We use daily stock returns to examine the announcement effect of stock market liberalization. effect of stock market liberalization.

We also use financial statement data to calculate proxies for We also use financial statement data to calculate proxies for the growth opportunities, free cash flow, and control the growth opportunities, free cash flow, and control variables.variables.

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In this study, we follow Mitton (2002) to use stock returns In this study, we follow Mitton (2002) to use stock returns as the measure of firm performance during periods of stock as the measure of firm performance during periods of stock market liberalization. market liberalization.

We do not calculate abnormal stock returns through the use We do not calculate abnormal stock returns through the use of historical betas. of historical betas.

As an alternative, we use measures of firm size, leverage, As an alternative, we use measures of firm size, leverage, dividend yield, industry dummies, and country dummies in dividend yield, industry dummies, and country dummies in the regressions to control for those factors that could affect the regressions to control for those factors that could affect expected returns. expected returns.

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To empirically distinguish the effects of investment To empirically distinguish the effects of investment opportunities, a proxy for the profitability of new opportunities, a proxy for the profitability of new investment is required. investment is required.

Tobin’s Tobin’s qq, defined as the ratio of a firm’s market value to , defined as the ratio of a firm’s market value to the replacement costs of its assets, is perhaps the most the replacement costs of its assets, is perhaps the most commonly used measure of growth opportunities (Denis, commonly used measure of growth opportunities (Denis, 1994). 1994).

We estimate We estimate qq as the ratio of the market value of the firm’s as the ratio of the market value of the firm’s assets to the book value of the firm’s assets, where the assets to the book value of the firm’s assets, where the market value of assets equals the book value of assets minus market value of assets equals the book value of assets minus the book value of common equity plus the market value of the book value of common equity plus the market value of common equity. common equity.

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This simple measure of This simple measure of qq for investment opportunities has for investment opportunities has been widely used in previous studies (e.g., Smith & Watts, been widely used in previous studies (e.g., Smith & Watts, 1992, and Holderness et al., 1999). 1992, and Holderness et al., 1999).

The The qq variable is measured at the end of the fiscal year variable is measured at the end of the fiscal year preceding the announcement of stock market liberalization. preceding the announcement of stock market liberalization.

High-High-qq firms are regarded as firms with good investment firms are regarded as firms with good investment opportunities while low-opportunities while low-qq firms are regarded as firms with firms are regarded as firms with poor investment opportunities.poor investment opportunities.

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Jensen (1986) defines free cash flow as cash flow left after Jensen (1986) defines free cash flow as cash flow left after the firm has invested in all available positive NPV projects. the firm has invested in all available positive NPV projects.

Unfortunately, as pointed out by Lang et al. (1991), the Unfortunately, as pointed out by Lang et al. (1991), the literature provides little or no guidance on the measures for literature provides little or no guidance on the measures for free cash flow as defined by Jensen (1986). free cash flow as defined by Jensen (1986).

We thus adopt the most widely used definition of free cash We thus adopt the most widely used definition of free cash flow, which is operating income before depreciation minus flow, which is operating income before depreciation minus interest expenses, taxes, preferred dividends, and common interest expenses, taxes, preferred dividends, and common dividends for the fiscal year preceding the announcement dividends for the fiscal year preceding the announcement (e.g., Lehn & Poulsen, 1989; Lang et al., 1991; Lie, 2000). (e.g., Lehn & Poulsen, 1989; Lang et al., 1991; Lie, 2000).

Free cash flow is normalized by the book value of total Free cash flow is normalized by the book value of total assets. assets.

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We also control for other potential variables that could We also control for other potential variables that could affect firm performance. affect firm performance.

The first control variable is firm size, which is measured by The first control variable is firm size, which is measured by the logarithm of the book value of total assets for the fiscal the logarithm of the book value of total assets for the fiscal year preceding the announcement. year preceding the announcement.

Chui & Wei (1998) find a strong size effect in emerging Chui & Wei (1998) find a strong size effect in emerging markets, where stock returns are negatively related to firm markets, where stock returns are negatively related to firm size. size.

Laeven (2003) also points out that the effects of financial Laeven (2003) also points out that the effects of financial liberalization in emerging countries differ between small liberalization in emerging countries differ between small and large firms. and large firms.

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Another control variable used in this study is the firm’s Another control variable used in this study is the firm’s debt ratio, which is measured as the book value of total debt debt ratio, which is measured as the book value of total debt divided by the book value of total assets for the fiscal year divided by the book value of total assets for the fiscal year preceding the announcement. preceding the announcement.

The debt ratio reflects the firm’s leverage risk and is related The debt ratio reflects the firm’s leverage risk and is related to the stock returns. to the stock returns.

Moreover, debt can be used to monitor managerial Moreover, debt can be used to monitor managerial inefficiency and mitigate the agency problem (Hart & inefficiency and mitigate the agency problem (Hart & Moore, 1990, and Stulz, 1990). Moore, 1990, and Stulz, 1990).

Thus, the debt ratio may affect a firm’s performance. Thus, the debt ratio may affect a firm’s performance.

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Finally, dividend yield, which is defined as the firm’s Finally, dividend yield, which is defined as the firm’s dividend to price per share for the year preceding the dividend to price per share for the year preceding the announcement, is included as an alternative measure of announcement, is included as an alternative measure of investment opportunities (Smith & Watts, 1992). investment opportunities (Smith & Watts, 1992).

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Empirical ResultsEmpirical Results

Overall Effect of Stock Market Liberalization on Overall Effect of Stock Market Liberalization on Stock ReturnsStock Returns (Table III) (Table III)

Following Henry (2000a), we use an eight-month Following Henry (2000a), we use an eight-month period (–7, 0) to measure the price reaction to the period (–7, 0) to measure the price reaction to the announcement of stock market liberalization, where announcement of stock market liberalization, where month 0 is defined as the month of liberalization. month 0 is defined as the month of liberalization.

We examine the announcement-period returns for all We examine the announcement-period returns for all three types of stock market liberalization. three types of stock market liberalization.

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• Subsample Analysis by Investment Opportunities and Subsample Analysis by Investment Opportunities and Free Cash Flow Free Cash Flow (Table IV)(Table IV)

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• Cross-Sectional Regression Analyses Cross-Sectional Regression Analyses (Table V)(Table V)

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• Robustness Checks: Various Window Lengths of Robustness Checks: Various Window Lengths of Announcement-Period Returns Announcement-Period Returns (Table VI)(Table VI)

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• Robustness Checks: Alternative Measures of Robustness Checks: Alternative Measures of Announcement-Period Returns Announcement-Period Returns (Table VII)(Table VII)

We obtain estimates of abnormal stock returns on the basis of the We obtain estimates of abnormal stock returns on the basis of the market model, with the abnormal return being calculated as the market model, with the abnormal return being calculated as the difference between the actual return and an expected return difference between the actual return and an expected return generated by the market model. generated by the market model.

We estimate the parameters of the market model using data over We estimate the parameters of the market model using data over the period from month –20 to month –9 before the month of stock the period from month –20 to month –9 before the month of stock market liberalization. market liberalization.

The cumulative abnormal returns are calculated by summing up The cumulative abnormal returns are calculated by summing up the daily abnormal returns over each event window. the daily abnormal returns over each event window.

We compute the buy-and-hold returns by compounding the daily We compute the buy-and-hold returns by compounding the daily returns over each event window.returns over each event window.

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• Robustness Checks: Alternative Measures of Free Cash FlowRobustness Checks: Alternative Measures of Free Cash Flow (Table VIII)(Table VIII)

Three alternative free cash flow proxies (Lang et al., 1991): Three alternative free cash flow proxies (Lang et al., 1991):

(1) net income plus depreciation plus adjustment for other elements (1) net income plus depreciation plus adjustment for other elements in income that do not affect working capital, divided by the book in income that do not affect working capital, divided by the book value of total assets;value of total assets;

(2) operating income before depreciation minus interest expense, (2) operating income before depreciation minus interest expense, taxes, preferred dividends, and common dividends, divided by the taxes, preferred dividends, and common dividends, divided by the book value of equity;book value of equity;

(3) the same definition of free cash flow as in (2), divided by the sum (3) the same definition of free cash flow as in (2), divided by the sum of the book value of equity and the book value of long-term debt. of the book value of equity and the book value of long-term debt.

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• Robustness Checks: Alternative Measure of Valuation ImpactRobustness Checks: Alternative Measure of Valuation Impact (Table IX)(Table IX)

We examine the valuation effects as measured by Tobin’s We examine the valuation effects as measured by Tobin’s qq rather than rather than announcement-period returns (as in Morck et al., 1988, and Carter et al., announcement-period returns (as in Morck et al., 1988, and Carter et al., 2006). 2006).

We use data on our sample firms over the period 1980-1998 to examine We use data on our sample firms over the period 1980-1998 to examine changes in Tobin’s changes in Tobin’s qq surrounding all three types of stock market surrounding all three types of stock market liberalization, with the results. liberalization, with the results.

The dependent variable in Models 1 and 2 is the growth rate of Tobin’s The dependent variable in Models 1 and 2 is the growth rate of Tobin’s qq, , while the dependent variable in Models 3 and 4 is the change in Tobin’s while the dependent variable in Models 3 and 4 is the change in Tobin’s qq. .

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The explanatory variable is the liberalization dummy The explanatory variable is the liberalization dummy variable (variable (STST), which equals one for the year of stock ), which equals one for the year of stock market liberalization, and zero otherwise. market liberalization, and zero otherwise.

We also control for the potential effects of country- and We also control for the potential effects of country- and industry-specific differences by including industry and industry-specific differences by including industry and country dummies in the regressions. country dummies in the regressions.

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Wealth Impact of Banking LiberalizationWealth Impact of Banking Liberalization • Banking liberalization is another important type of financial Banking liberalization is another important type of financial

liberalization. liberalization.

However, unlike stock market liberalization, banking sector However, unlike stock market liberalization, banking sector liberalization occurs gradually over a longer period of time. liberalization occurs gradually over a longer period of time.

The prior literature provides examinations of 6 types of The prior literature provides examinations of 6 types of banking liberalization, including the liberalization of interest banking liberalization, including the liberalization of interest rates, the removal of entry barriers, the lowering of reserve rates, the removal of entry barriers, the lowering of reserve requirements, the removal of credit controls, the privatization requirements, the removal of credit controls, the privatization of state-owned banks, and the introduction of prudential of state-owned banks, and the introduction of prudential regulation (Laeven, 2003; Abiad & Mody, 2005).regulation (Laeven, 2003; Abiad & Mody, 2005).

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If banking liberalization is accompanied by a reduction If banking liberalization is accompanied by a reduction in financial frictions, such as improved contract in financial frictions, such as improved contract enforcement or a reduction of information costs, then it enforcement or a reduction of information costs, then it will ultimately reduce a firm’s financing constraints will ultimately reduce a firm’s financing constraints and increase its access to investment funds (Laeven, and increase its access to investment funds (Laeven, 2003).2003).

We investigate the stock valuation impact of banking We investigate the stock valuation impact of banking liberalization at firm level for the emerging markets in liberalization at firm level for the emerging markets in our sample. our sample.

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In order to investigate the announcement effect In order to investigate the announcement effect associated with banking market liberalization, we need associated with banking market liberalization, we need monthly data on the banking liberalization events for monthly data on the banking liberalization events for each country. each country.

Such data on financial liberalization for the emerging Such data on financial liberalization for the emerging markets is provided by Kaminsky & Schmukler (2003) markets is provided by Kaminsky & Schmukler (2003) and Bekaert and Harvey (2004). and Bekaert and Harvey (2004).

We thus obtain the banking liberalization dates from We thus obtain the banking liberalization dates from their studies.their studies.

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We find that for the whole sample of fourteen emerging We find that for the whole sample of fourteen emerging economies, the average (median) eight-month (–7, 0) economies, the average (median) eight-month (–7, 0) announcement-period return is 0.119% (0.058%) per day announcement-period return is 0.119% (0.058%) per day for all 6 types of banking liberalization, statistically for all 6 types of banking liberalization, statistically significant at the 1% level. significant at the 1% level.

Our evidence suggests that at firm level, the average Our evidence suggests that at firm level, the average (median) increase in stock returns during periods of (median) increase in stock returns during periods of banking liberalization is approximately 2.4% (1.2%) per banking liberalization is approximately 2.4% (1.2%) per month. month.

Therefore, consistent with our findings on stock market Therefore, consistent with our findings on stock market liberalization, banking liberalization announcements are liberalization, banking liberalization announcements are associated with significantly positive stock valuation effects. associated with significantly positive stock valuation effects.

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The explanatory role of investment opportunities and The explanatory role of investment opportunities and free cash flow on the value-enhancing potential of free cash flow on the value-enhancing potential of banking liberalization banking liberalization (Table X)(Table X)

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SummarySummary• We find that at firm level, financial liberalization

announcements are, on average, associated with significantly positive stock returns, consistent with previous findings.

• We further show that the average market reaction to such announcements is more favorable for firms with high growth opportunities than for those with low growth opportunities.

Our results are consistent with the investment opportunities hypothesis and continue to hold after controlling for other factors which could affect market responses to such announcements.

Our findings suggest that the availability, or lack, of investment opportunities is an important consideration in assessing the value of financial liberalization.

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SummarySummary• We also find that free cash flow explains the cross-sectional

differences in stock returns associated with financial liberalization announcements.

We show that high-cash-flow firms have lower announcement-period returns than low-cash-flow firms.

Our findings are consistent with the expectation under the free cash flow hypothesis that the value of financial liberalization has an inverse relationship with firms’ existing free cash flow levels.

Our results suggest that the free cash flow hypothesis dominates the corporate governance hypothesis in terms of the net effect of financial liberalization on the firms’ stock returns.