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Two essays on corporate governance and earnings quality

Authors Chen, Zhihong
Issue Date 2005
Summary Expected returns of investment project and cost of capital are two important factors that affect firm's investment behavior. The first essay empirically tests the effect of accounting information quality on firms' use of accounting information in capital investment decisions. I argue that the quality of internally used accounting information is highly correlated with that of the externally reported information. Based on the earnings quality measure by Dechow and Dichev (2002), I find that the sensitivity of capital investment to lagged earnings is stronger when firms have higher earnings quality, after controlling for Tobin's Q, contemporaneous cash flows from operating, and the interaction effects of financial constraints and stock price informativeness. Moreover, the stronger sensitivity is not only driven by cash flows component, but also by accrual component of earnings. The evidence is consistent with the hypothesis that mangers rely more on accounting information in capital budgeting process when accounting information quality is higher. The second essay focuses on firm's cost of capital. This paper explicitly examines the impact of agency problems on the marginal benefit of corporate governance on the reduction of cost of capital. I find that firms with stronger shareholder rights have a significantly lower implied cost of capital, even after controlling for risk factors, price momentum, and analysts' biases. Furthermore, the effect of shareholder rights on the reduction of cost of capital is more profound for firms with higher agency risks and higher outside takeover threats. In particular, the marginal benefit of corporate governance on the reduction of cost of capital is higher for firms with higher free cash flows, poorer investment opportunities and lower insider ownership. The findings are consistent with the free-cash-flow hypothesis proposed by Jensen (1986) and the agency theory put forth by Jensen and Meckling (1976).
Note Thesis (Ph.D.)--Hong Kong University of Science and Technology, 2005
Language English
Format Thesis
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