Board independence and corporate investments

• Author: Wei Wang,Jun Lu
• Published date: 01 January 2015
• Date: 01 January 2015
• DOI: http://doi.org/10.1016/j.rfe.2015.01.001

Board independence and corporate investments

Jun Lu

a,1

,WeiWang

b,

⁎

a

ChineseAcademy of Finance and Development,Central Universityof Finance and Economics,China

b

ClevelandState University,1860 E. 18th St., BU 319, Cleveland,OH 44115, United States

abstractarticle info

Articlehistory:

Received30 June 2014

Receivedin revised form 20 November2014

Accepted24 January 2015

Availableonline 4 February 2015

JEL classification:

G30

G31

G32

Keywords:

Capitalinvestment

R&D investment

Agencyproblem

Board independe nce

SUR

This researchinvestigateswhether and how board independenceinfluences corporateinvestment decisionsin a

SeeminglyUnrelated Regression(SUR) framework, wherethe capital investmentand the research and develop-

ment (R&D) investmentare examined simultaneously.We argue that the free cash flow problem primarily in-

flicts capital investment s, while the managerial co nservatism mainly unde rcuts the more risky R&D

investments. Consistent with independent board mitigating both agency problems, we find that firms with a

higherdegree of board independenceis negatively associatedwith capital investmentsbut positively associated

with R&D investments,after controllingfor common determinantsof investments. We address theendogeneity

of board independenceby exploiting an exogenous change in board structure broughtabout by the Sarbanes–

Oxley Act (SOX)and continue to find consistentresults.

© 2015 ElsevierInc. All rights reserved.

1. Introduction

There has been heightened attention to the corporate governance

issues among both policymakers and academics since the Enron scandal

in 2001 and the subprime crisis in 2008. To address these issues, a

frequent recipe is to enhance the independence of company boards.

The Sarbanes–Oxley Act of 2002 (hereafter, SOX), for example, mandated

that a majority of board members be independent and all audit commit-

tee members be independent; the Dodd–Frank Act of 2010 went further

to require that compensation committees consist of only outside

directors. In this background, Bebchuk and Weisbach (2012) point

out, “given the growing importance of independent directors, ….itis

important to study empirically the effects of director independence.”

(Page 329).

Surprisingly,while how various corporategovernance mechanisms

influencefirm value and corporateactivities hasbeen intensively exam-

ined, empirical evidenceon the relation between board independence

and corporate investments,often viewed as the most important value

driver for a business, is scarceand inconclusive. In this paper, we take

on the issue to investigate, in a unified framework, whether and how

board independence affects a firm's investments in both physical and

knowledgeassets, i.e., capital investmentsand R&D investments.

Economic theory suggests that capital investments and R&D in-

vestments are driven by similar considerations, and that one could

use the present value of future cash flow streams to evaluate the de-

sirability of either investment. The q theory holds that in a frictionless

world, investment should be determined only by q,ameasureof

growth opportunities (Tobin, 1969). In an imperfect world, however,

agency problems often cause a firm's investments to deviate from the

optimal levels dictated by the q theory. In particular, the separation of

ownership and management could give rise to the free cash flow

problem and excessive conser vatism in investments. On one hand, a

self-serving manager tends to make investments beyond the optimal

level to harvest the private benefits of empire building when free cash

flows are available (e.g., Jensen, 1986; Stulz, 1990). On the other hand,

an incentive for the manager, who is less diversified and hence more

risk-averse than shareholders, to protect his wealth and career creates

excessive avoidance of risky investments, leading to underinvestment

(e.g., Amihud & Lev, 1981; Hirshleifer & Thakor, 1992).

Two major differencesexist between capital and R&D investments.

First, capital investments bri ng about tangible assets that end up in

balance sheets and increase total book asse ts. R&D investments, in

contrast, are treated as expenses under the current acc ounting stan-

dards and typically do not raise a firm's book as sets. Second, the

Reviewof Financial Economics 24 (2015)52–64

⁎Correspondingauthor. Tel.:+ 1 216 8759854.

E-mailaddresses: lujun@cufe.edu.cn(J. Lu), w.wang24@csuoh io.edu (W. Wang).

1

Tel.: +86 10 622884 69.

http://dx.doi.org/10.1016/j.rfe.2015.01.001

1058-3300/©2015 Elsevier Inc. All rightsreserved.

Contents listsavailable at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe