Corporate Governance, Product Market Competition, and the Wealth Effect of R&D Spending Changes

• Author: Wen‐Chun Lin,Tsai‐Ling Liao
• DOI: http://doi.org/10.1111/fima.12161
• Date: 01 September 2017
• Published date: 01 September 2017

Corporate Governance, Product Market

Competition, and the Wealth Effect

of R&D Spending Changes

Tsai-Ling Liao and Wen-Chun Lin∗

This article examines whether corporate governance and product market competition interact

to affect the profitability of corporate research and development (R&D) investments. Firms an-

nouncing R&D spending changes experience positive and significant wealth effects, and these

effects are mainly driven by good-governance firms. Investors appear to view announcements

of R&D spending changes undertaken by firms with stronger shareholder rights as evidence of

value creation. Moreover, the favorable wealth effects are stronger for good-governance firms

in noncompetitive industries than in competitive industries, supporting the argument that good

governance substitutes for productmarket competition.

Prior studies have analyzed the relation betweenresearch and development (R&D) investments

and the firm’s market value (Griliches, 1981; Jaffe, 1986; Hall, 1993; Chan, Lakonishok, and

Sougiannis, 2001; Eberhart, Maxwell, and Siddique, 2004; Hall and Oriani, 2006; Oriani and

Sobrero, 2008, among others), as well as stock returns following corporate R&D announcements

(Chan, Martin, and Kensinger, 1990; Woolridge and Snow, 1990; Szewczyk, Tsetsekos, and

Zantout, 1996; Sundaram, John, and John, 1996; Xu, Magnan, and Andr´

e, 2007, among others).

Typically, empirical results show that firms’ R&D expenditures are positively related to current

and future market values as well as future profitability. In addition, stock prices react positively

to announcements of R&D increases.

Prior studies have also examined factors affecting the valuation effects of corporate R&D

strategies. Empirical results show that R&D intensity, firm size, investment opportunities, debt

ratio, market concentration, and institutional ownership have positive effects on the ability of

R&D investment to create firm value (e.g., Chan et al., 1990; Doukas and Switzer, 1992; Chauvin

and Hirschey, 1993; Sundaram et al., 1996; Szewczyk et al., 1996; Cannolly and Hirschey, 2005;

Pindado, Queiroz, and Torre, 2010), whereas free cash flows and capital intensity have negative

valuation effects on R&D (Szewczyk et al., 1996; Zantout, 1997). These findings suggest that

there can be distributional consequences to announcements of R&D investments.

An unanswered question in the literature is whether corporate governance mechanisms affect

investor valuations of R&D spending. In addition, the literature has not investigated whether

governance mechanisms and product market competition interact to affect the efficiency of

We thank Raghavendra Rau (Editor), an anonymous referee, and seminar participants at the Fourth Asian Conference

on the Social Sciences for their valuable comments and suggestions on this paper. Financial support from the National

Science Council of Taiwan(NSC 100-2410-H-126-010) is gratefully acknowledged. An earlier version of this paper was

titled “Corporate Governance, ProductMarket Competition, and the Wealth Effect of R&D Investments.”

∗Tsai-Ling Liao is an Associate Professor in the Department of Business Administrationat the College of Management at

National FormosaUniversity, Taiwan. Wen-Chun Lin is an Associate Professor in the Department of Finance at National

Taipei Universityof Business, Taiwan.

Financial Management •Fall 2017 •pages 717 – 742

718 Financial Management rFall 2017

corporate R&D expenditures.1To the extent that R&D investments are subject to high levels of

information asymmetry between managers and investors, R&D activities maygive rise to agency

concerns (Aboody and Lev, 2000; Ho, Tjahijapranata, and Yap, 2006; He and Wang, 2009).2

Without proper monitoring and bonding, managers can and often do make suboptimal investment

decisions to extract private benefits at the expense of shareholders. Therefore, well-designed

governance mechanisms should channel managerial effort toward the efficient deployment of

corporate R&D resources. Giroud and Mueller (2010, 2011) find that f irms in noncompetitive

industries benefit more from good governance than do firms in competitive industries. Hence,

it follows that the extent to which the expropriation or rent-seeking potential of a firm’s R&D

resources is fully realized will depend on both the effectiveness of corporate governance and

the degree of product market competition in deterring unproductive resource deployment by

managers and in providing managers with the proper incentives to maximize current shareholder

wealth.

We argue that the wealth effect associated with announcements of corporate R&D spending

changes is likely to be more favorablefor well-governed firms in noncompetitive industries than in

competitive industries. Unlike previousstudies on announcements of R&D expenditure increases,

we focus on firms announcing changes in R&D spending, which include both increases and

decreases in R&D expenditures.3Hence, our investigations enable a comparison between these

twosubsamples and provide a better understanding about the nature of corporate investment policy

in R&D changes. Furthermore, because little research examines the valuation of R&D reductions

(Chan, Lin, and Wang, 2015), exploring the announcement effects of R&D changes expands

the literature on the valuation of R&D spending. Following the prior literature (e.g., Gompers,

Ishii, and Metrick, 2003; Bebchuk and Cohen, 2005; Core, Guay, and Rusticus, 2006; Bebchuk,

Cohen, and Ferrell, 2009; Wang and Xie, 2009), we use four indices of antitakeover provisions

to proxy for the quality of corporate governance.4Product market competition is measured using

the Herfindahl index (HI), and the wealth effect is measured in terms of abnormal stock returns

using the market-adjusted returns model and the trading volume around the announcements of

R&D expenditure changes.

In a sample of firms announcing changes in R&D spending from 1988 to 2014, we find that the

average announcement-period abnormal return for announcing firms is positive and significant.

Good-governance firms mainly exhibit a positive effect. Hence, R&D changes undertaken by

firms with stronger shareholder rights appear to increase investor confidence that the R&D

activities are indeed value creating. Furthermore, good-governance firms in noncompetitive

industries earn more favorable R&D announcement stock returns than do good-governance firms

in competitive industries. Finally, we find a significant increase in trading volume turnover

around the R&D announcement days for good-governance firms in noncompetitive industries.

For both R&D-increasing and R&D-decreasing subsamples, we also find a similar pattern of

higher R&D announcement returns for good-governance firms in noncompetitive industries than

1A related paper by Chung, Wright, and Kedia (2003) indicates that the market valuation(Tobin’s q) of the firm’scapital

and R&D investments depends critically on analyst followingand board composition, but not on institutional holdings.

However, Chung et al. (2003) do not consider the impact of shareholder rights and the interaction between corporate

governance and product market competition on the shareholder wealth effectsof R&D investments, as we do here.

2Supporting this view,Jensen (1993) indicates that many firms’ R&D investments are not profitable and detrimental.

3Wethank the editor for pointing out this thesis in relation to R&D-decreasing announcements.

4Several studies show that firms with stronger shareholder rights or fewer antitakeover provisions are associated with

higher market value (Gompers et al., 2003; Bebchuk and Cohen, 2005; Bebchuk et al., 2009) and better operating

performance (Core et al., 2006).