Three Essays on Capital Budgeting and Allocation Efficiency
Creators: Zhang, Xiaowen
Publisher: name: University of Alberta Library
Year: 2023

<p>This dissertation consists of three essays concerning corporate economic efficiency. More specifically, I document how efficiently firms have used and allocated capital over the last three decades in the U.S. and worldwide. More importantly, I explore firm characteristics that affect their efficiency, emphasizing the effects of governance quality, institutional ownership, and size. I also study the mechanisms through which these traits impact the efficient use and allocation of capital. Overall, an understanding of how closely firms&#39; investment decisions are aligned with shareholder value maximization and how well capital is allocated to the best available growth opportunities -- referred to as capital budgeting efficiency and capital allocation efficiency in this thesis, respectively -- helps us to evaluate firms&#39; investment behaviour, comprehend the investment dynamics, and understand the real economic consequences of the stock market. </p>

<p>Chapter 1 explores the impact of quasi-indexers -- a predominant type of institutional investor characterized by a highly diversified portfolio, long holding periods, and low turnover -- on a firm&#39;s capital budgeting efficiency and potential mechanisms through which that quasi-indexers may affect firms&#39; efficiency. Following Durnev, Morck, and Yeung (2004), I use the deviation of a firm&#39;s marginal q from the optimal level as a measure of the firm&#39;s capital budgeting inefficiency. I instrument quasi-indexer ownership by the S&amp;P 1500 index membership and exploit the relationship between a firm&#39;s capital budgeting efficiency and its quasi-indexer ownership within a small distance around the size-rank inclusion threshold, and find that quasi-indexer improved firms&#39; capital budgeting efficiency, dominated by the alleviation of underinvestment. Moreover, the improvement is more substantial for firms with more research and development investment, which is not directly affected by quasi-indexer ownership, pointing to the information channel that quasi-indexers affect capital budgeting efficiency. </p>

<p>Chapter 2 examines whether more substantial shareholder rights drive firms&#39; marginal q closer to or further away from the optimal level, indicating firms&#39; capital budgeting inefficiency. I utilize governance indices -- cumulant indices of corporate provisions that delegate controls to managers -- to capture the opposite of the strength of firms&#39; shareholder rights following Gompers, Ishii, and Metrick (2003) and Bebchuk, Cohen, and Gerrell (2009). In contrast to existing evidence of a positive relationship between shareholder rights and firms&#39; market valuation, I find that weaker shareholder rights are associated with more value-enhancing capital budgeting decisions. The results are robust to instrumenting governance index by the average corresponding governance indices in previous years of focus firms&#39; non-industry, geographically proximate peers or peers going public in the same year as the firm in question, following Karpoff, Schonlau, and Wehrly (2017). The negative relationship between shareholder rights and capital budgeting efficiency is more pronounced for younger firms and firms with more competent managers, indicating that strong shareholder rights may limit managers&#39; discretion in making efficient decisions. Furthermore, I find evidence suggesting cash holdings and operation volatility are the mechanisms that shareholder rights affect capital budgeting efficiency.</p>

<p>Chapter 3 outlines the capital allocation efficiency of firms around the world. This work contributes to the literature by analyzing the heterogeneity of capital allocation efficiency at the firm level across countries and examining whether and how financial development disproportionately affects small and large public firms in terms of economic efficiency. More specifically, following the insights of Wurgler (2000), I measure capital allocation efficiency as the elasticity of a firm&#39;s investment to its sales, of which growth reflects the firm&#39;s growth opportunities. I find that capital is allocated more efficiently among large firms. A larger financial market improves only large firms&#39; capital allocation efficiency. In contrast, the price informativeness of the stock market is associated with a higher allocation efficiency among both large and small firms. These findings suggest that the informational efficiency of financial markets is vital for allocating capital to its best use. </p>