Investment,leverage and political risk: Evidence from project-level FDI

Does capital structure influence firms' FDI capital expenditure decisions into countries with varying degrees of political risk? We explore this question using a novel dataset that matches 10,000 unique outward foreign direct investment (OFDI) projects with 1135 distinct U.S. firms over the period 2003–2014. We find that capital expenditures allocated to FDI projects are significantly lower for highly leveraged firms, in particular for firms with low growth opportunities. Firms also commit lower capital amounts to investments located in countries characterized by higher political risk. Furthermore, leverage and political risk interact with one another in determining the financial commitment of the FDI, with leverage exerting a significantly stronger negative effect on capital expenditures in countries where political risk is elevated. Our findings are consistent with the monitoring role of debt in curbing exposure to political risk in multinational firms' foreign operations, and corroborate the disciplinary role of leverage on firms' investment decisions.     

Capital structure with risky foreign investment

Firms facing significant business risks have incentives to mitigate the costs of these risks by adjusting their capital structures. This paper investigates this link by analyzing the exposures of multinational firms to political risk. The evidence indicates that returns on investment in politically risky countries are more volatile than returns elsewhere. Multinational firms reduce their leverage in response to these political risks: a one standard deviation increase in foreign political risk is associated with 3.5% reduced leverage. The effect of foreign political risks on leverage is most pronounced for firms in industries whose returns are most susceptible to political influence.     

Auditors' Response to Political Connections and Cronyism in Malaysia

This paper extends the literature on the role of political economy in financial reporting and auditing by testing two hypotheses. The first hypothesis predicts that there will be a greater increase in audit effort and audit fees for Malaysian firms with political connections, as a result of the Asian financial crisis, than for non‐politically connected firms because these firms have a higher risk of financial misstatements. The second hypothesis predicts that the audit fees of politically connected firms will decline when capital controls are introduced by the government as a ploy to financially assist politically connected firms to rebound from the crisis, and thus reduces the risk of financial misstatements. The results show that there is a greater increase in audit fees for firms with political connections than for non‐politically connected firms as a result of the Asian financial crisis. However, there is a decline in audit fees for politically connected firms after the capital controls are implemented.     

Policy and oversight of corporate political activities and the cost of equity capital

This paper investigates the effect of voluntary adoption and disclosure of policies/oversight of corporate political activities/spending on the cost of equity capital for S&P 500 firms over the period 2015–2018. Using the CPA-Zicklin Index to measure the level of policies, oversight, and disclosure of corporate political activities, we find that firms with a greater level of policies and oversight enjoy a lower cost of equity capital. We also document that a higher index is associated with higher stock liquidity. The negative relation is more pronounced among firms with higher exposure to political risk and firms with higher dependence on government spending. We also find that a firm’s information environment plays an important role in moderating the relation between policies and oversight of corporate political activities and the cost of equity capital. Our findings suggest that voluntary adoption and disclosure of policies and oversight mitigates risks and uncertainties related to firms’ political activities, thereby reducing information asymmetry and the cost of equity capital.     

Firm-level political risk and distance-to-default

This study provides the first empirical evidence of the relationship between firm-level political risk and distance-to-default. Based on our examination of a quarterly dataset of 2727 U.S. firms covering a period from January 2002 to April 2019, we conclude that firm-level political risk is negatively associated with distance-to-default. We document three economic mechanisms through which political risk increases default risk: information asymmetry, organizational capital, and investment growth. The evidence indicates that the association is more pronounced for firms with low analysts’ forecast accuracy, organizational capital, and investment growth. Employing hand-collected data, we also reveal that firms are able to exploit their corporate lobbying to immunize themselves against default risk. Our findings are robust to different endogeneity identifications, including a natural experiment, alternative distance-to-default proxies, and different sub-samples. Overall, we present novel evidence of an adverse impact of firm-level political risk on distance-to-default and how such a negative effect can be mitigated.     

Motivations behind human capital disclosure in annual reports

Although much has been discussed about voluntary disclosure of human capital in annual reports there has been limited examination of the motivations behind such disclosure. This study uses the perspective of the political economy of accounting to understand motivations. Using the method of content analysis, this paper examines human capital disclosure practices in annual reports of a sample of firms in Sri Lanka, a developing nation. Eleven case study interviews from the sample explore the motivations behind the disclosure practices of firms. Findings reveal that firms use disclosure to reduce tension between firms and their constituents, in the interest of further capital accumulation.     

Firm-level political risk and corporate leverage decisions

This study examines the effects of firm-level political risk on firm leverage decisions and speed of adjustment. We uncover that firm-level political risk has a negative impact on a firm's total and long-term leverage. We also find that firms facing high political risk tend to prefer debts with short-term maturity. However, firm-level political risk is positively related to debt specialisation, suggesting that firms are more inclined to adopt fewer debt types when they face high political risk. Further analysis reveals that firms with high political risk are associated with a faster speed of adjustment to target than those with low political risk. Our results are robust to endogeneity concerns and the effects of financial crisis.     

Political Risk as a Determinant of Southern European FDI in Neighboring Developing Countries

This study analyzes foreign direct investment flows from southern European countries to one of two nearby developing regions: north African countries and new European Union member states in central and eastern Europe. As expected, good economic perspectives, human capital, and development of infrastructures attract greater investment flows. However, greater levels of political risk, measured through scales of political discretion, corruption, and economic freedom, do also attract higher inflows. Despite the fact that one might expect global flows to fall as a consequence of political risk, those from the countries in the sample increase, because they come from firms that are searching for a market niche where they can take advantage of their political capabilities.     

Earnings Quality and Market Values of Indonesian Listed Firms

We find that earnings quality (EQ) is reliably negatively correlated with the market values of equity of firms listed on the Jakarta Stock Exchange (IDX). The financial reporting process produces earnings viewed as increasingly ‘incomplete’ for valuation purposes by the capital market despite moves towards high‐quality financial reporting standards (IFRS) during the sample period 1995–2015. Time‐series analyses reveal that EQ decreases rather than increases through time. The role of earnings in valuation is replaced by other attributes, most notably net dividends. Firms that pay out dividends are valued significantly higher, and firms that issue equity are valued lower. These results are robust regardless of other accounting, market and governance controls. Large and closely held firms are valued higher than smaller firms, consistent with some aspects of the political cost hypothesis. Shares with higher idiosyncratic risk are valued higher, consistent with option value, as are shares where the volume of shares traded is more volatile. Collectively, the results indicate that the mere adoption of high‐quality accounting standards (IFRS) and other nominal changes in capital market regulations do not automatically increase the quality of the financial reporting process.     

THE EFFECTS OF COMPLEX CAPITAL STRUCTURE ON THE MARKET VALUES OF FIRMS

The familiar Modigliani and Miller risk class model is the basis of a test for differences in value between simple and complex capital structure groups of firms. Cluster analysis, using market risk measures and debt-equity ratio as input, provides the method for obtaining the risk class sample of firms. Crosssectional tests at three annual dates are made on twenty-six simple and twentysix complex capital structure firms. For all periods examined, the complex capital structure firms are valued lower than the simple capital structure firms. Possible explanations for the results include failure of the arbitrage mechanism and the presence of certain costs associated with different types of capital structures.     

Accruals Quality, Information Risk and Cost of Capital: Evidence from Australia

Abstract:  Recent theoretical work argues that information risk is a non-diversifiable risk factor that is priced in the capital market. Using accruals quality to proxy for information risk, Francis et al. (2005) provide empirical support for this argument using a sample of US firms. This paper re-examines the interplay of accruals quality, information risk and cost of capital in Australia, where a number of important institutional and regulatory differences are hypothesized to affect the relation between accruals quality and cost of capital. The results suggest that, while accruals quality impacts on the cost of capital for Australian firms, some salient differences exist. In contrast to findings for US firms, the costs of debt and equity for Australian firms are largely influenced by accruals quality arising from economic fundamentals (i.e., innate accrual quality) but not discretionary reporting choices (i.e., discretionary accrual quality). This finding is consistent with our predictions based on the Australian institutional and regulatory environment. In addition, using both the asset pricing tests in Francis et al. (2005) and Core et al. (2008) , we provide evidence consistent with accruals quality being a priced risk factor.     

Political rights and equity pricing

We examine the influence of political rights on the implied cost of equity capital using a sample of firms from 44 countries. We find that firms' equity financing costs are lower when political rights are stronger. We further find that political institutions' direct impact on the cost of equity capital is incremental to that of legal institutions. Economically, our results imply that a one standard deviation increase in political rights is associated with a 38 basis point decrease in corporate cost of equity capital. In additional analyses, we find that the effect of political rights on equity pricing is more pronounced in countries with weak legal institutions.     

Political connections and the cost of equity capital

Motivated by recent research on the costs and benefits of political connection, we examine the cost of equity capital of politically connected firms. Using propensity score matching models, we find that politically connected firms enjoy a lower cost of equity capital than their non-connected peers. We find further that political connections are more valuable for firms with stronger ties to political power. In additional analyses, we find that the effect of political connection on firms' equity financing costs is influenced by the prevailing country-level institutional and political environment, and by firm characteristics. Taken together, our findings provide strong evidence that investors require a lower cost of capital for politically connected firms, which suggests that politically connected firms are generally considered less risky than non-connected firms.     

THE CAPITAL BUDGETING BEHAVIOUR AND CORPORATE CHARACTERISTICS OF CAPITAL-CONSTRAINED FIRMS

This paper addresses (1) the nature and pervasiveness of organisational constraints, frnancial and otherwise, on investment, and (2) the corporate characteristics and capital budgeting behaviour of capital-constrained firms for a sample of 126 UK companies. The results indicate that corporate size, risk and profitability are important corporate characteristics in this regard, and that financially-constrained firms tend to adopt naive capital budgeting methods in resolving the capital rationing problem.     

Climate risk: The price of drought

We document a significant positive relation between drought risk and the cost of equity capital. Our estimation shows that the cost of equity capital is 92 basis points higher for firms affected by severe drought conditions. We provide evidence that when firms are affected by droughts, firms with higher local institutional holdings exhibit a higher cost of equity capital. This result supports the well-known local bias of institutional investors, and suggests that diversification cannot fully eliminate the loss in wealth caused by droughts. Consistent with theoretical predictions, we find that drought duration and drought intensity further increase a firm's risk premium. However, for firms with diversified cash flows/investments, geographically dispersed business operations, and high cash holdings, the impact of drought on the expected return is significantly lessened. Overall, our findings show that investors require a higher rate of returns on firms affected by droughts and offer implications on how firms can mitigate the impact of droughts on their cost of capital.     

The impact of D&O insurance on excess corporate leverage

The governance effects of directors’ and officers’ liability insurance (D&O insurance), an important tool for risk diversification, are of strong concern in the capital market. Using a sample of Chinese A-share listed firms from 2009 to 2018, we examine the impact of D&O insurance on excess corporate leverage. We find that D&O insurance is negatively associated with excess corporate leverage and that this result is consistent with a series of robustness tests. Further analyses show that D&O insurance impedes excess corporate leverage mainly because of its effect on external monitoring. The effect is more pronounced for firms that are state-owned, have political connections and are located in provinces with low marketization than for other firms.     

What do private firms do after losing political capital? Evidence from China

This paper studies the real effects of losing political capital by exploiting exogenous shocks from the sudden deaths of politically connected independent directors in Chinese firms. Using difference-in-differences estimation, we find that upon losing political capital, a firm boosts its physical capital expenditures by 28%, or 2.93 percentage points, which is an order of magnitude larger than estimates from the United States. The loss of political capital leads to a decrease in the economic benefits a firm can obtain, in terms of bank loans, tax benefits, and government subsidies, and an increase in its production costs. Our evidence suggests that private firms use physical capital investment as a substitute for political capital.     

Stock pledging and firm risk: Evidence from India

Pledging of personally held common stock is widespread in India, where pledging often serves as lender collateral for large shareholder and promoter personal debt acquisitions. This practice is exacerbated by high ownership concentrations in India, as promoters, often firm founders, control, on average, 51% of their firms’ equity. We examine promoter stock pledging impacts on stock volatility, capital investment decisions, and firm performance, using a sample of 1,452 Indian firms. We find that pledging relatively large proportions of outstanding shares and substantial proportions of shares held by promoters exacerbates stock volatility, fosters lower risk capital investments, adversely affects firm values, and impedes longer‐term performance.     

Organization capital and corporate cash holdings

This paper investigates the relationship between organization capital and corporate cash holdings. We develop two competing hypotheses in relating organization capital with cash holding. Our analysis reveals that organization capital is related to high levels of cash holdings. Moreover, we find that the effect of organization capital on corporate cash holdings is stronger for firms experiencing high levels of financing constraint and cash flow risk. Our results remain robust to alternative measures of organization capital and corporate cash holdings, and are not driven by omitted variable bias or endogeneity issues. We also find that the positive relation between organization capital and cash holdings is not confounded by sample period or industry group. Overall, we provide robust evidence that supports the precautionary motive for corporate cash holding.     

Political costs and corporate tax avoidance: Evidence from sin firms

The products and services of firms operating in sin industries (alcohol, tobacco, gambling, and firearms) run contrary to social norms and can produce significant negative externalities for society. As such, we expect that sin firms are at greater risk of incurring political costs in the form of additional regulation, higher excise taxes, or capital market intervention if they come under scrutiny for their income tax avoidance practices. Because of the nature of their products, regulators and policymakers are likely to face less pushback on new regulations or taxes on these firms. Sin firms start with a lower ability to influence the political process than firms in non-sin industries. Consequently, we hypothesize and find that sin firms exhibit less tax avoidance than non-sin firms, particularly through uncertain and more risky tax avoidance strategies. The negative relationship between the status of sin firms and tax avoidance is less pronounced in firms that accumulate political capital via intensive lobbying activities. Exploiting changes in partisan control of the Congress and White House, difference-in-differences tests show that firearm firms engage in less (more) tax avoidance when the Democrats (Republican) control both the Congress and White House. Overall, we conclude that political costs play an important role in corporate tax avoidance decisions.