Investor Protection and Corporate Valuation

The authors of this research begin with a discussion of the problem background to the study in which concerns are raised as to how local laws can be used to influence the investment climate in a country. Investors are assumed to be risk averse and likely to invest in countries where there are sound laws in place to protect their investments from expropriation by controlling shareholders.

One study has shown that this trend favours development of financial markets because, knowing that their rights are well protected by the law, investors, be they shareholders or creditors will be more willing to pay more for financial assets because of the higher potential returns involved. Country specific factors however account for differences in the pace with which financial markets are developing in different countries. (La Porta et al, 2001)

Prior studies cited in La Porta et al’s paper, have focussed on the benefits of legal investor protection for financial development, but how are these protective investment laws impacting on firm value? Such is the research question that the authors are out to investigate and provide explanations to, while bearing in mind the differences that exist in ownership structures and control among firms within and across countries. This is because these differences affect the power and incentives of controlling shareholders to expropriate minority shareholders.

(La Porta et al, 2001) Theoretical Framework The study has reviewed extensive literature on related studies while highlighting key conclusions. These range from topics like the incentive effect of managerial cash flow ownership, the central agency problems in large publicly traded firms, the effects of corporate ownership structures on valuation to the influence of law on corporate ownership structures, dividend policies, size of firms, the efficiency of investment allocation, economic growth and even the susceptibility of a country’s financial markets to crash.

Recent literature reviewed touches on a range of issues – the relationship between voting premium and valuation, the effect of managerial ownership on the profitability and valuation of U. S. firms, the effects of entrepreneurial control and cash flow ownership on the valuation of firms in many East Asian countries and the effects of bank ownership on the valuation of German firms. Empirical Analysis and Definition of Parameters

In light of the problem background and objective, and using the Tobin’s q, the authors then perform an empirical investigation of the effect of protective investor laws and ownership by controlling shareholders on firm value for 539 firms selected from 27 wealthy economies. To better assess the effect of investor protection on corporate valuation, both the power and the incentives to expropriate are held constant. (La Porta et al, 2001). Some key parameters are defined for clarity and better interpretation of results. Summarized as follows (La Porta et al, 2001):

Indicators of shareholder protection – Origin of a country’s laws and the index of specific legal rules. Incentive effects of ownership – Only companies that have controlling shareholders are considered here to keep the power to expropriate relatively low. Measure of Incentives – Cash flow ownership by the controlling shareholder. Consistent with theory, the study came up with the finding that better shareholder protection is empirically associated with higher valuation of corporate assets. It was also found that higher incentives from cash flow ownership are associated with higher valuations.

(La Porta et al, 2001) Model Specification, Assumptions and Hypotheses Model Assumptions La Porta et al (2001) makes the following assumptions that govern the model developed: There is only one controlling shareholder This controlling shareholder has cash flow or equity ownership, Alpha, in the firm Alpha is exogenously determined by the history and the life-cycle of the firm, and do not consider the sale of equity by the entrepreneur The entrepreneur is the manager Model Specification as Stated in La Porta et al (2001) The firm has an amount of cash I, which it invests in a project with a rate of return R.

The firm has no costs, so the profits are RI  (the scale of investment does not matter) The entrepreneur can divert a share, s of the profits from the firm to himself before distributing the rest as dividends. (Diversion that is not theft involves costs) As a consequence of the costs of such legal expropriation, when the entrepreneur diverts share s of the profits, he is left with sRI – c(k,s)RI, Where c (k,s) = share of the profits that he wastes when s is diverted, c =  cost-of –theft function and k = quality of shareholder protection.

The following inequalities are assumed: ck>0 means stealing is costlier in a more protective legal regime, cs>0 means marginal cost of stealing is positive, css>0 means that the marginal cost of stealing rises as more is stolen, cks>0 means that the marginal cost of stealing is higher when investors are better protected. It is assumed that the cost c is borne by the entrepreneur rather than by all the shareholders.