Corporate control and underinvestment
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Corporate control and underinvestment Thomas Poulsen
Published online: 13 April 2011 Ó Springer Science+Business Media, LLC. 2011
Abstract This paper reports a study of how the benefits that large shareholders derive from their control of a firm affect the equity issue and investment decisions of the firm. I introduce an explicit agency cost structure based on the benefits of control of the largest shareholder. In a simple extension of the model developed by Myers and Majluf (J Financial Econ 13:187–221, 1984), I show that underinvestment is aggravated when there are benefits of being in control and these benefits are diluted if equity is issued to finance an investment project. Using a large panel of US data, I find that the concerns of large shareholders about the dilution of ownership and control cause firms to issue less equity and to invest less than would otherwise be the case. I also find that it makes no significant difference whether new shares are issued to old shareholders or new shareholders. Keywords Equity issue Underinvestment Private benefits of control Potential loss of control Voting power JEL Classification
G31 G32
1 Introduction The rent-protection theory developed by Bebchuk (1999) suggests that concentrated ownership structures arise because control is too valuable to large shareholders to leave it up for grabs. In such cases, to preclude a ‘‘control grab’’, large shareholders prefer to bear agency costs rather than relinquish control. This paper reports a study
T. Poulsen (&) Center for Corporate Governance, Department of International Economics and Management, Copenhagen Business School, Porcelaenshaven 24, 2000 Frederiksberg, Denmark e-mail: [email protected]
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of how large shareholders with benefits of control affect capital-constrained firms’ equity issue behavior and investment decisions. Finance theory presupposes that firms evaluate investment opportunities as if they had ample cash. In efficient capital markets, the net present value of selling securities is always zero, because the cash raised exactly balances the present value of the liability created. Where such markets prevail, the appropriate decision rule is to accept each project with a positive net present value, regardless of whether internal or external sources are used to pay for it. The adverse selection model developed by Myers and Majluf (1984) suggests that firms with profitable investment opportunities may be unable to finance them because asymmetric information about future states cause new equity to be underpriced. This is because the firm’s management acts in the interest of the existing/controlling shareholders. Such agency costs create adverse selection problems and constrain the supply side in the provision of equity capital. In this paper, the adverse selection problem comes from the demand side instead. I introduce an explicit agency cost structure based on the benefits of control enjoyed by the largest shareholder. In a simple extension of the Myers and Majluf (1984) model, I sh
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