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Topics: Investment, Governance, Emerging markets Pages: 29 (10277 words) Published: April 24, 2013
EMEMAR-00307; No of Pages 15
Emerging Markets Review xxx (2012) xxx–xxx

Contents lists available at SciVerse ScienceDirect

Emerging Markets Review
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Corporate governance and investment-cash flow sensitivity: Evidence from emerging markets Bill Francis a, Iftekhar Hasan b,⁎, Liang Song c, 1, Maya Waisman d, 2 a

Lally School of Management, Rensselaer Polytechnic Institute, 110, 8th Street, Troy, NY 12180-3590, United States Fordham University and Bank of Finland, 1790 Broadway, 11th Floor, New York, NY 10019, United States c Michigan Technological University, 1400 Townsend Drive Houghton, MI 49931, United States d Fordham University, 1790 Broadway, 13th Floor, New York, NY 10019, United States b

a r t i c l e
Available online xxxx JEL classification: G20 G30 G31 G38

i n f o

a b s t r a c t
Controlling for country-level governance, we investigate how firms' corporate governance influences financing constraints. Using firm-level corporate governance rankings across 14 emerging markets, we find that better corporate governance lowers the dependence of emerging market firms on internally generated cash flows, and reduces financing constraints that would otherwise distort efficient allocation of investment and destroy firm value. Additionally and more importantly, firm-level corporate governance matters more significantly in countries with weaker country-level governance. This suggests substitutability between firm-specific and country-level governance in determining a firm's investment sensitivity to internal cash flows. © 2012 Elsevier B.V. All rights reserved.

Keywords: Corporate governance Emerging markets Investment–cash flow sensitivity

1. Introduction How firms make investment decisions in the face of financing constraints is one of the most fundamental questions in contemporary finance research (Almeida and Campello, 2007). This is the case because financing constraints can distort the efficient allocation of investment and destroy firm value (Agca and Mozumdar, 2008; Stein, 2003). Indeed, an extensive amount of theoretical and empirical research finds a strong relationship between external financing constraints and poor investment decisions, especially for badly governed companies (see, e.g., Almeida and Campello, 2007; Brown and Petersen, 2009; Hovakimian, 2009). These studies contend that in the presence of agency problems associated with managerial control, investors

⁎ Corresponding author. Tel.: +1 646 312 8278. E-mail addresses: (B. Francis), (I. Hasan), (L. Song), (M. Waisman). 1 Tel.: +1 906 487 4368. 2 Tel.: +1 212 636 6717. 1566-0141/$ – see front matter © 2012 Elsevier B.V. All rights reserved.

Please cite this article as: Francis, B., et al., Corporate governance and investment-cash flow sensitivity: Evidence from..., Emerging Markets Review (2012),


B. Francis et al. / Emerging Markets Review xxx (2012) xxx–xxx

require higher returns on their capital as compensation for monitoring costs (Jensen, 1986; Stulz, 1990). This restricts managers' access to external financing, forces them to rely more heavily on low-cost limited internal funds, and limits their ability to accept positive net present value projects. Although the extant literature provides ample evidence of the impact of country-level governance— such as the efficiency of the legal system, the rule of law, the risk of expropriation, corruption, and legal origin—on firms' investment–cash flow sensitivity (see, e.g., Love, 2003; Lins et al., 2005), there is little if any evidence on the relationship between investment–cash flow sensitivity and firm-level corporate governance, especially in emerging market firms. 3 More importantly, it is still an open question whether firm- and country-specific governance mechanisms substitute or complement...
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