Credit Ratings and Corporate Investment: UK Evidence

Transcription

1 Credi Rings nd Corpore Invesmen: UK Evidence Credi Rings nd Corpore Invesmen: UK Evidence Hong Bo Deprmen of Finncil & Mngemen Sudies SOAS, Universiy of London, UK Rober Lensink Deprmen of Finnce Universiy of Groningen, The Neherlnds Vicor Murinde Deprmen of Accouning & Finnce Universiy of Birminghm, UK All Correspondence o: Hong Bo Deprmen of Finncil & Mngemen Sudies School of Orienl nd Africn Sudies Universiy of London, Thornhugh Sree, Russell Squre London WC1H XG Tel: +44() Fx: +44 () E-mil: SOAS Universiy of London

2 Discussion Pper 95 Credi Rings nd Corpore Invesmen: UK Evidence Absrc We invesige he effec of credi rings on corpore invesmen. We exend he convenionl view, which predics posiive liner relionship beween credi rings nd firm invesmen, by highlighing perspecive of corpore governnce h emphsizes he impc of mngeril creer concerns. The evidence from pnel of 576 UK public nonfinncil firms during shows h in ddiion o he convenionl view, here re severl oher possibiliies which describe he relion beween credi rings nd fixed invesmen. Specificlly, we find h: () he relion beween credi rings nd invesmen my be nonliner nd cn be represened by n invered U curve; (b) chnges in credi rings re negively ssocied wih invesmen; (c) he negive effec of he chnges in credi rings on invesmen is excerbed by high levels of credi rings; nd (d) he resuls in (b) nd (c) re more pronounced for firms h re fcing credi rings upgrdes. JEL Clssificions: G4, G31, M51 Keywords: credi rings, corpore invesmen, mngeril creer concerns, UK firms Cenre for Finncil nd Mngemen Sudies 1

3 Credi Rings nd Corpore Invesmen: UK Evidence Credi Rings nd Corpore Invesmen: UK Evidence 1. Inroducion For richer or poorer, credi ring gencies seem o be rcing lo of enion. For exmple, recen reserch suggess h credi rings direcly ffec cpil srucure decisions o he exen h he pecking order nd rde-off cpil srucure heories re grely enhnced by incorporing discree coss nd benefis of ring chnges (Kisgen, 6, 7 nd 8). Credi rings lso end o influence IPO pricing: An nd Chn (8) show h when firms issue IPOs, hose wih credi rings re less vulnerble o underpricing hn firms wihou credi rings. Bu ody ring gencies re highly criicised s culpris in he subprime morgge crisis, for undersing he risk involved wih morgge-bcked securiies. I is ineresing h he cul implicions of credi rings my conrdic convenionl expecions, in erms of risk monioring by finncil regulors, impc on cpil srucure decisions by firms, or perhps corpore invesmen decisions. Perhps, he behviour of corpore finncil mngers lso mers. We focus on he implicions of credi rings for corpore invesmen decisions. The convenionl view is h when firm is seeking exernl deb finncing for fixed invesmen, is credi repuion mers. Poenil exernl lenders end o rely on hird pry, nmely credi ring gency, o vouch for he credi repuion of he firm. Credi ring gencies provide he public wih n evluion of he firm s quliy in erms of eiher is overll crediworhiness or he deful risk of priculr deb securiy. A firm s overll credi ring reflecs ring gency s opinion of he firm s overll crediworhiness nd is cpciy o sisfy is finncil obligions. Poenil exernl lenders lwys prefer o lend o good quliy firms, where good quliy is normlly indiced by high credi rings score ssigned o he firm. Therefore, i is commonly cceped h high credi rings indice good quliy of he firm; he firm cn borrow more lower coss in order o expnd invesmen, hence he firm s fixed invesmen is posiively ssocied wih credi rings. This view is consisen wih he finncil consrin lierure, semming from SOAS Universiy of London

4 Discussion Pper 95 work by Fzzri e l. (1988). In his lierure, wheher or no he firm hs credi rings is ken s n indicor for he firm o hve more ccess o exernl deb finncing lower coss (e.g. Whied, 199; Kpln nd Zingles, 1997). However, he bove-menioned convenionl view on he relionship beween credi rings nd invesmen is perhps rue if we only consider he supply side of exernl finncing, i.e. if we ssume h he firm will borrow s much s he supply llows. This view emphsizes oo much he finncil consrins fced by he firm becuse i ssumes h he firm is finncilly consrined nd will use up whever finncing is vilble o i. The convenionl view my no be susinble if he demnd side for exernl finncing is lso considered. Our pper exmines he relion beween credi rings nd fixed invesmen by king ino considerion boh he demnd nd supply sides nd hus deprs from he convenionl view of he relionship beween credi rings nd fixed invesmen. We rgue h he firm my no use up ll vilble supply of exernl finncing for fixed invesmen due o mngeril creer concerns of he decision-mkers. For exmple, mngers my no find high credi rings score rcive due o mngeril creer concerns. Mngeril creer concerns refer o he fc h mngers my mnipule he decision-mking process in order o proec heir repuion in he mngeril lbour mrke nd o influence he ex-pos lbour mrke ssessmen of heir humn cpil (Holmsröm, 1999). When credi rings re oo high o susin, he firm will fce higher probbiliy o hve credi rings downgrde in he ner fuure. Mngers will do heir bes o void credi rings downgrdes becuse downgrding dmges mngers repuion nd leds o negive ssessmens of heir biliy in he mngeril lbour mrke. This ype of mngeril creer concerns becomes more pronounced if he firm is opering under high uncerin exernl environmen. Fcing high exernl unceriny, mngers re no sure bou invesmen oucomes, herefore hey prefer o mke sfer invesmen decisions by invesing less hn hey should, in order o void credi ring downgrdes. This is priculrly he cse when he firm is sruggling o minin high level of credi rings nd is cully fcing Cenre for Finncil nd Mngemen Sudies 3

5 Credi Rings nd Corpore Invesmen: UK Evidence higher probbiliy of being downgrded. For exmple, mngers cn choose invesmen projecs h enble hem o influence he ex-pos ssessmen of he credi rings gency on he quliy of he firm. Hence, some invesmen disorions my rise due o mngeril creer concerns. One possible invesmen disorion h my resul from mngeril creer concerns is underinvesmen or lck of innovion nd conservion in invesmen (see Zwiebel, 1995, nd Prendergs nd Sole, 1996). The bove-menioned noion my explin some sylized fcs on credi rings. For exmple, i my explin he observed declining rend of credi rings, priculrly in corpore Americ (Blume e l., 1998; lso, he New York Times, November 11, 6). This declining rend my be explined by he fc h mngers my no like o rge high credi rings. To exend he convenionl view on he relion beween credi rings nd firm invesmen, we presen evidence showing h here re severl oher possibiliies h cn describe he relion beween credi rings nd fixed invesmen. Using pnel of 576 UK public nonfinncil firms over he period , we find h: () he relionship beween credi rings nd invesmen my be nonliner nd cn be represened by n invered U curve, which implies h when he level of credi rings is oo high nd beyond cerin hreshold, higher level of credi rings is ssocied wih lower invesmen; (b) chnges in credi rings re negively ssocied wih chnges in firm invesmen; (c) he negive effec of he chnges in credi rings on invesmen is excerbed by high levels of credi rings; nd (d) he resuls in (b) nd (c) re more pronounced for firms h re fcing credi rings upgrdes. The reminder of he pper is orgnized s follows. Secion reviews he reled lierure. Secion 3 discusses some empiricl issues. Secion 4 presens empiricl nlyses on he relion beween credi rings nd corpore invesmen. Secion 5 concludes. In he ppendix, we presen heoreicl model o illusre he ide h mngers my use fixed invesmen decisions o influence he ssessmen of credi ring gencies on he quliy of he firm; in urn, he ex-pos percepion of he quliy of he firm lers invesmen behviour. 4 SOAS Universiy of London

6 Discussion Pper 95. Lierure Review The reserch ide of his pper is synhesized from les wo srnds of he economics nd finnce lierure. The firs srnd focuses on mngeril creer concerns nd sems from he work by Fm (198) who clims h explici incenive conrcs re no necessry for he firm since he lbour mrke disciplines mngers. Holmsröm (1999), however, rgues h he biliy of he mnger is reveled over ime vi he hisory of his performnce. Using forml heoreicl model, Holmsröm shows h s long s he mnger s biliy is no compleely known by he mngeril lbour mrke, he mnger hs srong moivion o mnipule he decision-mking process in order o influence ssessmen by he mrke. Gibbons nd Murphy (199) provide differen perspecive o he view by Fm (198) nd Holmsröm (1999) by rguing h even in he presence of explici conrcs, creer concerns re sill imporn incenives. Hence, in brod conex where incenive conrcs conin boh explici nd implici componens nd he design of opiml compension schemes is imporn, he foregoing discussion suggess h mngeril creer concerns ply n imporn role in corpore decisions. Indeed, some scholrs hve invesiged explicily he relionship beween mngeril creer concerns nd invesmen. I hs been nlyiclly shown by Schrfsein nd Sein (199) h mngeril creer concerns moive he mngers o mimic ohers in mking corpore invesmen decisions (see lso Devenow nd Welch, 1996). Such herd behviour by mngers is furher invesiged by Zwiebel (1995). By linking corpore conservism wih mngeril repuionl concerns, Zwiebel (1995) finds h he ler my led mngers o refrin from deviing from he herd. Rher, mngers choose o ke inferior sndrd cions which serve s n ccure benchmrk for evluing fuure cions. Over ime, he lerning process beween impeuous youngsers nd jded old-imers furher ensures h mngeril creer concerns drive mngers o mke invesmen decisions, s shown by Prendergs nd Sole (1996). Cenre for Finncil nd Mngemen Sudies 5

7 Credi Rings nd Corpore Invesmen: UK Evidence The second srnd of he lierure reles o invesmen under finncil consrins nd emphsizes he fc h firms fce consrins in using exernl finncing for fixed invesmen (Fzzri, e l,. 1998). In his lierure, he credi ring of he firm is ken s n imporn indicor of he firm s biliy o ccess exernl deb finncing lower cos (e.g. Whied, 199; Kpln nd Zingles, 1997). I hs been shown h credi rings reduce informion symmery (Sufi, 7). Also, evidence shows h credi rings reduce he credi consrins fced by firms by enbling highly red firms o rise more deb (Fulkender nd Peersen, 6). In ddiion, in he nlyicl models by Boo e l. (6), invesors rionlly bse heir invesmen nd pricing decisions on credi rings. The cler line of rgumen is h firm wih higher credi rings is ble o ccess more exernl finncing for invesmen lower cos, such h one plusible inerpreion of he impc of credi rings on he firm s invesmen, ccording o his lierure, is h he firm s higher credi ring implies more invesmen. Hence, he relion beween credi rings nd invesmen is liner nd posiive. Besides he predicion of he finncil consrin lierure, Shh (6) documens h when he firm is fcing chnge in credi rings, i is likely o cu invesmen in order o keep sufficien csh reserve o void credi rings downgrde. This impc is more pronounced for firms which re more cively involved in deb mrkes. Finncil mngers re relucn o im for credi ring upgrdes, which my no be susinble. According o Shh (6), when i is grned high credi rings score, he firm will hen respond by cuing invesmen expendiure o sve some csh in order o void credi rings downgrde. However, i is imporn o sress h Shh (6) exmines he relion beween credi rings nd he firm s csh holding policy; invesmen is seen s chnnel hrough which credi rings ffec he csh holding policy of he firm. Our pper differs from Shh (6). We focus on he relion beween credi rings nd invesmen direcly; he chnnel hrough which credi rings ffec invesmen is mngeril creer concerns; effecively, herefore we synhesize he wo srnds of he lierure. 6 SOAS Universiy of London

8 Discussion Pper Empiricl Issues 3.1 Empiricl Specificions Moived by he heoreicl model which is presened in he ppendix, we specify n empiricl invesmen equion of he firm, which includes: () invesmen fundmenls; (b) exernl unceriny; nd (c) proxy for he firm s credi quliy. Specificlly, we use nnul growh re of sles ( SALES ) s he invesmen fundmenl vrible. The 3-yer moving sndrd deviion of csh flow scled by ol sses of he firm is used s n indicor of exernl unceriny ( UM ). We proxy for he firm s credi quliy by he level of nd he chnges in he QuiScore. We re priculrly ineresed in how credi rings nd heir chnges ffec he firm s invesmen decisions. Hence, we experimen wih he following lernive empiricl specificions: I K = fi + f + i β + 1 SALES i+ β UM i + β3cri ε i (1) I = fi + f + β 1 SALES i+ βumi + β3cri + β4cri + εi () K i I K = fi + f + i β + 1 SALES i+ βumi + β3cri + β4 CRi εi (3) I K = fi + f + i 1 SALES i+ βum i + β3cri + β4 CRi + β5( CRi * CRi ) εi (4) β + Where I i snds for invesmen for firm i in yer, which is mesured by ne chnges in fixed sses of he firm. K i is he beginning-of-period cpil sock of he firm mesured by ol sses of he firm. f i nd f re firm effecs nd ime effecs, respecively. re of sles for firm i in yer. UM i SALES i is he nnul growh is n mesure of exernl unceriny, which is he 3-yer moving sndrd deviion of csh flow scled by ol sses of he firm. CR i is he QuiScore Cenre for Finncil nd Mngemen Sudies 7

9 Credi Rings nd Corpore Invesmen: UK Evidence ssigned o firm i in yer. CRi is he chnge in he QuiScore for firm i in yer. ε i is n error erm. β s re he prmeers o be esimed for he explnory vribles. 3. D nd Mesuremen The d re ken from FAME, which is published by he compny Bureu vn Dijk. FAME collecs nd publishes compny level informion of UK nd Irish public nd prive compnies. Our smple includes only UK public nonfinncil firms h hve les five coninuous yers of observions. 1 Overll, we hve pnel of 576 firms over he period of , such h he ol number of firm-yer observions for he whole smple is 364. For he purposes of empiricl nlysis, we derived he following informion: ol sses, fixed sses, sles (urnover), csh flow, nd he QuiScore. The QuiScore is n indicor of he firm s overll finncil sbiliy nd cpciy. I is mesure of he likelihood of he firm s filure in he yer following he de of clculion. The QuiScore is ssigned on yerly bsis o he firm s number in he rnge o 1. A lrger vlue of he QuiScore indices beer finncil cpciy of he firm. The QuiScores is developed nd minined by CRIF Decision Soluions Limied. When deermining he QuiScore for nonfinncil firms, he gency CRIF Decision Soluions Limied kes ino ccoun rnge of fcors, including: () fcors reling o he finncil performnce of he firm s evidenced by he blnce shee nd profi nd loss semen; (b) he presence of ny dverse documens bou he firm nd he imeliness of geing he ccouns filed; nd (c) he underlying economic condiions. Hence, he QuiScore in our d revels he generl crediworhiness of he firm rher hn crediworhiness wih respec o priculr deb securiy. The QuiScore is used by ll pries involved in he firm, including deb issuers, bond 1 We lose wo observions in compuing he 3-yer moving sndrd deviions for csh flow in order o consruc he exernl unceriny mesure. By including only firms h hve les five coninuous yers of observions, we ensure h he shores ime series is 3 yers, which is required by he DPD98 GMM esimion progrmme. The Quiscore cn be furher clssified ino five bnds: 81-1 is he secure bnd; 61-8 is he sble bnd; 41-6 is he norml bnd; 1-4 cuion bnd; nd 1-, high risk bnd. 8 SOAS Universiy of London

10 Discussion Pper 95 invesors, porfolio mngers, nd oher mrke pricipns. In his sudy, herefore, he QuiScore is used s proxy for he firm s overll credi quliy in he cpil mrke. [Tble 1 bou here] Tble 1 presens summry sisics for he vribles used in he empiricl nlysis. As shown in Tble 1, he verge QuiScore for he smple firms is (medin 61) during he smple period, suggesing h he mjoriy of he smple firms hve relively sble finncil cpciy. In ddiion, Tble 1 shows h n verge smple firm experienced negive chnge in he QuiScore, s indiced by he fc h he men of he difference beween he curren yer s QuiScore nd he ls yer s QuiScore is Esimion Mehods Esimion nd esing of he empiricl equions re performed using he Generlised Mehod of Momens (GMM) procedure, which conrols for he endogenous problem nd llows for heerosckdsiciy. We follow Blundell nd Bond (1998) nd dop he sysem GMM esimion procedure in which momen condiions for equions in firs differences re combined wih momen condiions for equions in levels o compue he opiml weighing mrix h provides consisen sysem GMM esimors. The GMM esimion is conduced by using DPD98 for Guss (Arellno nd Bond, 1998). Time dummies re dded in ll esimions. We lso conrol for he indusry effec by dding indusry dummies. In heory, ll he ps observions of he righ-hnd side vribles cn be used s insrumens for he firs differenced equions in he sysem GMM esimions. In his pper he number of he lgged observions of he righ-hnd side vribles used s he insrumens for he firs difference equions vries slighly cross esimions. We use he Srgn es sisics o ssess he vlidiy of he chosen insrumens. In ddiion o he insrumens for he firs difference equions we use firs differences lgged once of he righ-hnd side vribles s he insrumens for he level equions. We repor wo-sep esimes wih correced sndrd errors bsed on Cenre for Finncil nd Mngemen Sudies 9

11 Credi Rings nd Corpore Invesmen: UK Evidence Windmeijer (5) who shows h wo-sep esimes re more efficien hn one-sep esimes. 4. Esimion Resuls We sr wih he simples empiricl model (equion 1) in which we es how he level of credi rings lone ffecs invesmen. The firs column of Tble shows h he esimed coefficien for he level of credi rings is highly significn wih posiive sign. This resul is consisen wih he convenionl view. Becuse higher level of credi rings is ken s n indicor of lower borrowing coss of nd more ccess o exernl finncing, he firm which hs higher credi rings score cn herefore borrow more funds lower coss, nd hence increse is invesmen. [Tble bou here] However, s we rgue in his pper h he liner nd posiive relion beween credi rings nd invesmen my no be susinble if we ke ino considerion he demnd side for exernl finncing. For exmple, s shown in he heoreicl model presened in he ppendix, mngeril creer concerns my led o lower invesmen when he level of credi rings is oo high o be susined, which suggess h he relion beween credi rings nd invesmen my be nonliner. The esimion resuls (bsed on empiricl model ()) shown in column () of Tble confirm our conjecure. I is ppren h lhough he esimed coefficien for he liner erm of credi rings is posiively significn, he esimed coefficien for he qudric erm of credi rings is negively significn. These resuls provide us wih n invered U shpe relion beween credi rings nd invesmen, which implies h when he level of credi rings is oo high beyond cerin hreshold, higher credi rings score is ssocied wih lower invesmen. We rgue in his pper h his ype of nonlineriy cn be explined by mngeril creer concerns. In Tble 3 we focus on he relionship beween he chnges in credi rings nd invesmen fer conrolling for he level of credi rings (he empiricl invesmen model (3)). We propose nd implemen hree lernive mesures of chnge in credi rings. Firs, he chnge in credi rings is mesured simply s he nnul chnge in credi rings, i.e. he difference beween 1 SOAS Universiy of London

12 Discussion Pper 95 he curren yer s QuiScore nd he firm s QuiScore in he previous yer: CR = CR CR 1. Second, he chnge in credi rings is mesured s he re of chnge in he firm s QuiScore, i.e. b CR = CR / CR 1 consruced from does no chnge, i.e. QuiScore, i.e.. Third, he chnge in credi rings is mesured s cegoricl vrible CR. We define CR =; nd CR >. Therefore, c CR =1 if c CR upwrd chnge in he firm s credi rings. c CR is negive; c CR = if he firm s QuiScore =3 if he firm experiences posiive chnge in he CR is cegoricl vrible wih lrger vlue indicing n [Tble 3 bou here] Wh is of priculr ineres in he empiricl resuls repored in columns 1-3 of Tble 3 is h no mer how we mesure he chnges in credi rings, we obin consisen resuls concerning he relion beween chnges in credi rings nd invesmen. In ll he hree vrins of empiricl equion (3), he esimed coefficien for he chnges in credi rings is highly significn wih negive sign. The resuls in Tble 3 confirm our conjecure h he firm negively recs o chnges in credi rings s fr s invesmen decisions re concerned. This resul cn be explined by he noion h mngers do no like chnges in credi rings due o mngeril creer concerns. Also, he resul is consisen wih he rgumen by Bernd nd Mullinnhn (3) h corpore execuives enjoy quie life. Thus chnges in credi rings, in priculr credi rings downgrdes, disurb he mngers quie life nd cully my dmge he mngers repuion in he mngeril lbour mrke. Therefore chnges in credi rings my led o sronger mngeril creer concerns, which in urn will led o sfer invesmen policy, which rgubly is chrcerised by reduced invesmen by he firm. If he mngers do no like he chnges in credi rings, hen i is logicl h he mngers hve inenion o cu invesmen fer he firm is credi upgrded becuse higher credi rings re more likely o bring bou credi rings downgrde in he ner fuure. Indeed, from column 3 of Cenre for Finncil nd Mngemen Sudies 11

13 Credi Rings nd Corpore Invesmen: UK Evidence Tble 3, we observe h upwrd chnges in credi rings hve negive effecs on invesmen, i.e. he firm inends o cu invesmen fer being upgrded. Therefore, i is ineresing o furher es wheher he negive impc of he chnges in credi rings on invesmen is reled o he level of credi rings. [Tble 4 bou here] In he esimions shown in Tble 4, we use he inercive erm beween he level of credi rings nd he chnges in credi rings (see he empiricl invesmen model (4)). Columns 1-3 of Tble 4 correspond o differen mesures of he chnges in credi rings CR b CR, nd c CR, respecively. I is o be noed h in wo ou of hree cses, he esimed coefficien for he inercive erm is negively significn, suggesing h he negive ssociion beween he chnges in credi rings nd invesmen is excerbed by high levels of credi rings. This resul suggess h high credi rings re no necessrily good for firm invesmen. One possible reson my be h high credi rings indice higher probbiliy of credi rings downgrde, herefore mngers would ke precuionry cions o void credi rings downgrdes by mking sfer invesmen decisions, for exmple, by cuing risky invesmen projecs. The evidence we hve obined so fr shows h here re severl oher possibiliies in ddiion o he convenionl view regrding he impc of credi rings on fixed invesmen: () he relion beween credi rings nd invesmen my be nonliner, which cn be presened by n invered U curve; (b) firm invesmen is negively ssocied wih he chnges in credi rings; (c) high levels of credi rings excerbe he negive effec of he chnges in credi rings on invesmen. These resuls, in priculr he resul (c) sugges h mngers do no lwys like high credi rings, hey my respond o high credi rings by cuing invesmen o void credi rings downgrde due o mngeril creer concerns. To provide furher evidence on his rgumen, we define dummy vrible which kes he vlue of one when he observion on he chnges in he firm s QuiScore is posiive, while i kes he vlue of zero oherwise, i.e. Dum ( up) = 1 nd 1 SOAS Universiy of London

14 Discussion Pper 95 ( 1 Dum ( up) ) =. The ide is o check wheher he firm responds o credi rings upgrdes differenly from he wy i responds o non-upwrd djusmens in credi rings. For he purpose of his pper, we focus on he differences beween upgrded nd non-upgrded cses in erms of how he firm responds o chnges in credi rings nd how he level of credi rings ffecs he relionship beween he chnges in credi rings nd invesmen. The empiricl specificions for his se of esimions re: 3 I K I K = i = i f i + f i + f + f + 1 SALESi + βcri + β3dum( up) * CRi + β4( 1 Dum( up) )* CRi εi (5) β + 1 SALESi + βcri + β3 CRi + β4dum( up) * ( CRi * CRi ) + β5( 1 Dum( up) )*( CRi * CRi ) εi (6) β + Tble 5 repors esimion nd esing resuls for empiricl model (5). I is shown h for ech of he hree vrins of he model, he esimed coefficiens for β 3 nd β 4 re differen: in ech cse, while he esimed coefficien for β 3 is negive nd sisiclly significn, he coefficien for β 4 is no significn. This evidence suggess h he firm is more likely o cu invesmen in response o credi rings upgrde. [Tbles 5 nd 6 bou here] Tble 6 repors he resuls of esiming he empiricl model (6) nd confirms h he inercive effec beween he level of credi rings nd chnges in credi rings lso differs beween credi rings upgrdes nd non-upgrdes. In ll he hree vrins of he equion, he esimed coefficien for he inercive erm beween he level of nd he chnges in credi rings is negively significn only for he credi rings upgrdes, while i is no significn for he nonupgrdes vrible. This resul suggess h for firms whose credi rings re upgrded, higher level of credi rings is more likely o led o lrger negive effec of he chnges in credi rings on invesmen s compred wih heir non-upgrded counerprs. The evidence shown in 3 We hd o drop he proxy for exernl unceriny in his se of esimions due o he non-posiive definie mrix problem. Cenre for Finncil nd Mngemen Sudies 13

15 Credi Rings nd Corpore Invesmen: UK Evidence Tbles 5 nd 6 provides even sronger suppor for our rgumen h here re oher possible explnions, in ddiion o he convenionl view, of he impc of credi rings on fixed invesmen. Moreover, his relion cn be nonliner one: when hey re oo high nd beyond cerin hreshold, credi rings re likely o led o downgrde; he downgrde will hen led o less invesmen. This resul cn be explined by he noion h higher credi rings inensify mngeril creer concerns; mngers will ke precuionry cions in mking invesmen decisions o proec heir repuion in he mngeril lbour mrke by cuing invesmen. 5. Conclusion In his pper, we exmine he relionship beween credi rings nd firm invesmen from corpore governnce perspecive, i.e. mngeril creer concerns. We rgue h he convenionl percepion h he relion beween credi rings nd invesmen is liner nd posiive is no susinble if we dd he firm s demnd for exernl finncing nd consider how mngeril creer concerns cn chnge his relionship. We suppor our rgumen by providing consisen evidence bsed on pnel of 576 UK public nonfinncil firms during We find h here re few oher possibiliies in ddiion o he convenionl view h cn describe he impc of credi rings on fixed invesmen, including () he relionship beween credi rings nd invesmen my be nonliner nd cn be represened by n invered U curve, which implies h when he level of credi rings is oo high nd beyond cerin hreshold, hen higher level of credi rings is ssocied wih lower invesmen. (b) he chnges in credi rings depress firm invesmen; (c) he negive effec of he chnges in credi rings on invesmen is excerbed by high levels of credi rings. (d) The resuls (b) nd (c) re more pronounced for he firms h re fcing credi rings upgrdes. Our resuls sugges h mngers my no like high credi rings due o mngeril creer concerns. Under he pressure of susining high credi rings, mngers would ke precuionry 14 SOAS Universiy of London

16 Discussion Pper 95 cions o void credi rings downgrdes by mking sfer invesmen decisions, for exmple, by cuing risky invesmen projecs. Cenre for Finncil nd Mngemen Sudies 15

17 Credi Rings nd Corpore Invesmen: UK Evidence References An, H., Chn, K.C. Credi rings nd IPO pricing. Journl of Corpore Finnce 8; 14; Arellno, M., Bond, S. Dynmic pnel d esimion using DPD98 for Guss: guide for users. Insiue for Fiscl Sudies (IFS) Working Pper 1998; No. 88/15. Berrnd, M., Mullinhn, S. Enjoying he quie life? Corpore governnce nd mngeril preferences. Journl of Poliicl Economy 3; 111; Blume, M. E., Lim, F., Mckinly, A.C. The declining credi quliy of U.S. corpore deb: myh or reliy? Journl of Finnce 1998; LIII (4); Blundell, R., Bond, S. Iniil condiions nd momen resricions in dynmic pnel d models. Journl of Economerics 1998; 87; Boo, A., Milbourn, T., Schmeis, A. Credi rings s coordinion mechnisms. Review of Finncil Sudies 6; 19; Cornell, B., Lndsmn, W., Shpiro, A. Cross-secionl regulriies in he response of sock prices o bond ring chnges. Journl of Accouning, Audiing nd Finnce 1989; 4; De Groo, M. Opiml sisicl decisions. McGrw-Hill: New York; 197. Devenow, A., Welch, I. Rionl herding in finncil economics. Europen Economic Review 1996; 4; Fm, E. F. Agency problems nd he heory of he firm. Journl of Poliicl Economy 198; 88; Fulkender, M., Peersen, M. Does he source of cpil ffec cpil srucure? Review of Finncil Sudies 6; 19; Fzzri, S.M., Hubbrd, R.G., Peersen, B.C. Finncing consrins nd corpore invesmen. Brookings Ppers on Economic Aciviy 1988; 1; Gibbons, R., Murphy, K.J. Opiml incenive conrcs in he presence of creer concerns: heory nd evidence. Journl of Poliicl Economy 199; 1; SOAS Universiy of London

18 Discussion Pper 95 Griffin, P., Snvicene, A. Common sock reurns nd ring chnges: A mehodologicl comprison. Journl of Finnce 198; 37; Holmsröm, B. Mngeril incenive problems: A dynmic perspecive. Review of Economic Sudies 1999; 66; Holhusen, R., Lefwich, R. The effec of bond ring chnges on common sock prices. Journl of Finncil Economics 1986; 17; Kpln, S., Zingles, L. Do invesmen-csh flow sensiiviies provide useful mesures of finncing consrins? Qurerly Journl of Economics 1997; 11; Kisgen, D. Credi rings nd cpil srucure. Journl of Finnce 6; LXI (3); Kisgen, D. The influence of credi rings on corpore cpil srucure decisions. Journl of Applied Corpore Finnce 7; 19(3); Kisgen, D. Do firms rge credi rings or leverge levels? Journl of Finncil nd Quniive Anlysis 8 (forhcoming). Lensink, R., Bo, H., Serken, E. Invesmen, cpil mrke imperfecions nd unceriny. Edwrd Elgr: Chelenhm; 1. Myers, S.C. Deerminns of corpore borrowing. Journl of Finncil Economics 1977; 5; Nrynn, M.P. Mngeril incenives for shor-erm resuls. Journl of Finnce 1985; 4; Prendergs, C., Sole, L. Impeuous youngsers nd jded old-imers: cquiring repuion for lerning. Journl of Poliicl Economy 1996; 14; Schrfsein, D.S., Sein, J.C. Herd behvior nd invesmen. Americn Economic Review 199; 8; Shh, R. Do firms reduce invesmen o void credi ring downgrdes? Working Pper, Finnce Deprmen, McCombs School of Business, Universiy of Texs 6. Cenre for Finncil nd Mngemen Sudies 17

19 Credi Rings nd Corpore Invesmen: UK Evidence Sufi, A. Informion symmery nd finncing rrngemens: evidence from syndiced lons. Journl of Finnce 7; 6; Whied, T.M. Deb, liquidiy consrins, nd corpore invesmen: evidence from pnel d. Journl of Finnce 199; 47; Windmeijer, F.A finie smple correcion for he vrince of liner efficien wo-sep GMM esimors. Journl of Economerics 5; 16; Zwiebel, J. Corpore conservism nd relive compension. Journl of Poliicl Economy 1995; 13; SOAS Universiy of London

20 Discussion Pper 95 Tble 1: Descripive Sisics nd Correlion Mrix for he Empiricl Vribles () Descripive Sisics Vribles Men Medin Sndrd Deviion Number of Observions I K SALES UM CR CR b CR c CR (b) Correlion Mrix I/K SALES UM CR CR b CR c CR I K 1. SALES UM CR CR b CR c CR Noes: (1) D source: FAME, 576 UK public firms during he period , ol firm-yer observion is 364. () Definiion nd mesuremen of vribles: I K : he rio of invesmen o he beginning of period cpil sock, where invesmen is he chnge in fixed sses of he firm. The cpil sock is mesured by ol sses of he firm. SALES: he nnul growh re of sles UM : is n exernl unceriny mesure, which is mesured by he 3-yer rolling sndrd deviion of CFTA, where CFTA is csh flow scled by ol sses of he firm. CR : credi ring score, which is he Quiscore. CR : he chnge in he QuiScore, which is mesured by he difference beween he curren yer s QuiScore nd he QuiScore in he previous yer, i.e. CR = CR CR 1. b b CR : he re of chnge in credi ring, i.e. CR = CR / CR 1. c CR : he chnge in credi ring, which is mesured by cegoricl vrible, which is consruced from CR s follows. We define i.e. CR =; CR c =3 if CR c =1 if CR is posiive. CR is negive; CR c = if he firm s QuiScore does no chnge Cenre for Finncil nd Mngemen Sudies 19

21 Credi Rings nd Corpore Invesmen: UK Evidence Tble : Is he Impc of Credi Rings on Firm Invesmen Liner or Nonliner? I = fi + f + β 1SALESi+ βumi + β3cri + εi K i I = fi + f + β 1SALES i+ βum i + β3cri + β4cri + ε i K i Sles i.61 (1.869) UM i (-1.86) CR i.315 (4.5671) Equion (1) Equion ().671 (.35) -.49 (-.63).73 (.786) CR -.41 i ( ) m m Srgn ( k ) P-vlue Wld es Chi-squre Insrumens (difference) (39) p=.799 H : β3 =.858(df=1) Sles UM CR Insrumens (levels) ( Sles ) 1 ( UM ) 1 ( CR ) (5) p=.815 H : β3 = β4 = (df=) Sles UM CR CR ( Sles ) 1 ( UM ) 1 ( CR ) 1 ( CR ) 1 Noes: (1) D source: FAME, 576 UK public firms during he period , ol firm-yer observion is 364. () The wo-sep esimes wih robus (correced) es sisics re repored. (3) Heeroskedsiciy consisen sympoic -sisics re in prenheses below he esimed coefficiens of he empiricl vribles. (4) m 1 nd m re ess for firs- nd second-order seril correlion in he firs-differenced residuls, sympoiclly disribued s norml disribuion under he null of no seril correlion. (5) Srgn (k): es of he overidenifying resricions, sympoiclly disribued s Chi-squre(df=k) under he null of insrumen vlidiy. (6) Wld es is he es sisics for he esimed coefficien is zero, disribued s Chi-squre(df) under he null of he esimed coefficien is zero. The criicl vlues of Chi-squre (df=1) re.76, 3.841, nd he 1%, 5% nd 1% significn levels, respecively. The criicl vlues of Chi-squre (df=) re 4.61, 5.99, nd 9.1 he 1%, 5% nd 1% significn levels, respecively. (7) Time effecs nd indusry effecs re conrolled for in he esimions. (8) See noes o Tble 1 for definiion nd mesuremen of vribles; df = degrees of freedom; p = p-vlue. SOAS Universiy of London

22 Discussion Pper 95 Tble 3: The Impc of Chnges in Credi Rings on Firm Invesmen I = fi + f + β 1SALES i+ βum i + β3cri + β 4 CRi + ε i K i Vrin (1) of Equion (3) ( CR i = CR i ) Sles i.814 (3.455) UM i (-.9731) CR i.333 (6.471) CR i -.6 (-3.916) Vrin () of Equion (3) b ( CR i = CR i ).717 (.1518) (-.8931).3745 (6.671) ( ) m m Srgn ( k ) P-vlue Wld es Chi-squre (df=1) Insrumens (difference) 5.134(64) p=.856 H Sles : β4 =, 3 UM CR CR, 3 Insrumens (levels) ( Sles ) 1 Noes: ( UM ) 1 ( CR ) 1 ( CR ) (58) p=.76 H 3.96 : β4 = Sles UM CR CR, 3 ( Sles ) 1 ( UM ) 1 ( CR ) 1 ( CR ) 1 Vrin (3) of Equion (3) c ( CR i = CR i ).858 (3.133) (-.9455).385 (5.1339) (-.68) (58) p=.944 H 4.46 : β4 = Sles UM CR CR, 3 ( Sles ) 1 ( UM ) 1 ( CR ) 1 ( CR ) 1 (1) D source: FAME, 576 UK public firms during he period , ol firm-yer observion is 364. () The wo-sep esimes wih robus (correced) es sisics re repored. (3) Heeroskedsiciy consisen sympoic -sisics re in prenheses below he esimed coefficiens of he empiricl vribles. (4) m 1 nd m re ess for firs- nd second-order seril correlion in he firs-differenced residuls, sympoiclly disribued s norml disribuion under he null of no seril correlion. (5) Srgn (k): es of he overidenifying resricions, sympoiclly disribued s Chi-squre(df=k) under he null of insrumen vlidiy. (6) Wld es is he es sisics for he esimed coefficien is zero, disribued s Chi-squre(df) under he null of he esimed coefficien is zero. The criicl vlues of Chi-squre (df=1) re.76, 3.841, nd he 1%, 5% nd 1% significn levels, respecively. (7) Time effecs nd indusry effecs re conrolled in he esimions. (8) See noes o Tble 1 for definiion nd mesuremen of vribles; df = degrees of freedom; p = p-vlue. Cenre for Finncil nd Mngemen Sudies 1

23 Credi Rings nd Corpore Invesmen: UK Evidence Tble 4: The Impc of Inercions beween Credi Rings nd heir Chnges on Firm Invesmen I = fi + f + K i β 1SALESi+ βumi + β3cri + β4 CRi + β5( CRi * CRi ) + εi Vrin 1 of equion (4) ( CR i = CR i ) Sles i.83 (.58) UM i (-1.83) CR i.89 (5.1354) CR i.16 (.6) CR i *CR -.77 ( ) Vrin of equion (4) b ( CR i = CR i ).678 (.13) -.53 (-.844).99 (4.956).355 (1.4861) ( ) m m Srgn ( k ) P-vlue Wld es Chi-squre (df=1) Insrumens (difference) (71) p=.91 H : β5 =.81 Sles, 3 UM CR CR CR * CR, ( ) 3 Insrumens (levels) ( Sles ) 1 Noes: ( UM ) 1 ( CR ) 1 ( CR ) 1 ( CR * CR) (65) p=.675 H : β5 = Sles UM CR CR CR * CR ( ) ( Sles ) 1 ( UM ) 1 ( CR ) 1 ( CR ) 1 ( CR * CR) 1 Vrin 3 of equion (4) c ( CR i = CR i ).865 (.9488) (-.719).77 (1.7687) -.36 (-.6944) -.5 (-.78) (65) p=.843 H : β5 =.7 Sles UM CR CR CR * CR ( ) ( Sles ) 1 ( UM ) 1 ( CR ) 1 ( CR ) 1 ( CR * CR) 1 (1) D source: FAME, 576 UK public firms during he period , ol firm-yer observion is 364. () The wo-sep esimes wih robus (correced) es sisics re repored. (3) Heeroskedsiciy consisen sympoic -sisics re in prenheses below he esimed coefficiens of he empiricl vribles. (4) m 1 nd m re ess for firs- nd second-order seril correlion in he firs-differenced residuls, sympoiclly disribued s norml disribuion under he null of no seril correlion. (5) Srgn (k): es of he overidenifying resricions, sympoiclly disribued s Chi-squre(df=k) under he null of insrumen vlidiy. (6) Wld es is he es sisics for he esimed coefficien is zero, disribued s Chi-squre(df) under he null of he esimed coefficien is zero. The criicl vlues of Chi-squre (df=1) re.76, 3.841, nd he 1%, 5% nd 1% significn levels, respecively. (7) Time effecs nd indusry effecs re conrolled in he esimions. (8) See noes o Tble 1 for definiion nd mesuremen of vribles; df = degrees of freedom; p = p-vlue. SOAS Universiy of London

24 Discussion Pper 95 Tble 5 The Impc of Chnges in Credi Rings on Firm Invesmen: Upgrded versus Non-upgrded Firms I = fi + f + K i β 1SALESi + βcri + β3dum( up) * CRi + β4( 1 Dum( up) )* CRi + εi Vrin 1 of Equion (5) ( CRi = CR i ) Sles i.1536 (.941) CR i.3151 (4.63) Dum( up) * CR i -.46 (-.1887) ( 1 Dum( up) )* CRi -.6 (-.4199) Vrin of Equion (5) b ( CRi = CR i ).859 (1.9888).977 (3.3358) ( ).355 (1.118) m m Srgn ( k ) P-vlue Wld es Chi-squre (df=) Insrumens (difference) (64) p =.37 : β3 = β4 = H 7.91 Sles CR ( Dum ( up) * CR), 3 1 Dum ( up) * CR, ( ) 3 Insrumens (levels) ( Sles ) 1 ( CR ) 1 ( Dum ( up) * CR) 1 ( 1 Dum ( up) * CR) 1 Noes: 5.84(57) p=.63 : β3 = β4 = H.851 Sles CR Dum ( up) * CR, 1 Dum ( up) * CR ( ) 3 ( ) 3 ( Sles ) 1 ( CR ) 1 ( Dum ( up) * CR) 1 ( 1 Dum ( up) * CR) 1 Vrin 3 of Equion (5) c ( CRi = CR i ).743 (1.7311).3718 (4.671) (-1.78) -.44 (-.8171) 54.43(56) p=.535 : β3 = β4 = H Sles 3 CR Dum ( up) * CR, 1 Dum ( up) * CR ( ) 3 ( ) 3 ( Sles ) 1 ( CR ) 1 ( Dum ( up) * CR) 1 ( 1 Dum ( up) * CR) 1 (1) D source: FAME, 576 UK public firms during he period , ol firm-yer observion is 364. () The wo-sep esimes wih robus (correced) es sisics re repored. (3) Heeroskedsiciy consisen sympoic -sisics re in prenheses below he esimed coefficiens of he empiricl vribles. (4) m 1 nd m re ess for firs- nd second-order seril correlion in he firs-differenced residuls, sympoiclly disribued s norml disribuion under he null of no seril correlion. (5) Srgn (k): es of he overidenifying resricions, sympoiclly disribued s Chi-squre(df=k) under he null of insrumen vlidiy. (6) Wld es is he es sisics for he esimed coefficien is zero, disribued s Chi-squre(df) under he null of he esimed coefficien is zero. The criicl vlues of Chi-squre (df=) re 4.61, 5.99, nd 9.1 he 1%, 5% nd 1% significn levels, respecively. (7) Time effecs nd indusry effecs re conrolled in he esimions. (8) See noes o Tble 1 for definiion nd mesuremen of vribles; df = degrees of freedom; p = p-vlue. Cenre for Finncil nd Mngemen Sudies 3

25 Credi Rings nd Corpore Invesmen: UK Evidence Tble 6: The Impc of he Inercions beween Credi Rings nd heir Chnges on Firm Invesmen: Upgrded versus Non-upgrded Firms I = fi + f + β 1SALESi + βcri + β3 CRi + β4dum( up) * ( CRi * CRi ) + β5( 1 Dum( up) )* ( CRi * CRi ) + εi K i Vrin 1 of Equion (6) ( CR i = CR i ) Sles i.174 (.811) CR i.331 ( 4.587) CR i.6 (.9369) Dum ( up) * ( CR * CR) i -.95 (-.191) ( 1 Dum ( up) )* ( CR * CR) i -.84 ( ) Vrin of Equion (6) b ( CRi = CR i ).169 (1.95).969 (4.618).438 (1.189) (-.48) ( ) m m (63).91 P-vlue Wld es H : β5 = β6 = Chi-squre (df=) Insrumens (dif.) Sles Srgn ( k ) CR CR [ Dum ( up) * ( CR * CR) ] 3 ( 1 Dum ( up) )*( CR * CR) [ ] 3 Insrumens (levels) ( Sles ) 1 ( CR ) 1 ( CR ) 1 [ Dum ( up) * ( CR * CR) ] 1 [ ( 1 Dum( up) )* ( CR * CR) ] 1 Noes: (64).648 H : β5 = β6 = Sles CR CR Dum ( up) * ( CR * CR) Dum ( up) * CR * CR [ ] [( 1 ) ( )] ( Sles ) 1 ( CR ) 1 ( CR ) 1 [ Dum ( up) * ( CR * CR) ] 1 [( 1 Dum( up) )* ( CR * CR) ] 1 Vrin 3 of Equion (6) c ( CRi = CR i ).114 (.4811).78 (4.9453).617 (1.3745) -.19 (-.5638) (-.766) 61.57(64).564 H : β5 = β6 = Sles CR CR Dum ( up) * ( CR * CR) Dum ( up) * CR * CR [ ] [( 1 ) ( )] ( Sles ) 1 ( CR ) 1 ( CR ) 1 [ Dum ( up) * ( CR * CR) ] 1 [( 1 Dum( up) )* ( CR * CR) ] 1 (1) D source: FAME, 576 UK public firms during he period , ol firm-yer observion is 364. () The wo-sep esimes wih robus (correced) es sisics re repored. (3) Heeroskedsiciy consisen sympoic -sisics re in prenheses below he esimed coefficiens of he empiricl vribles. (4) m 1 nd m re ess for firs- nd second-order seril correlion in he firs-differenced residuls, sympoiclly disribued s norml disribuion under he null of no seril correlion. (5) Srgn (k): es of he overidenifying resricions, sympoiclly disribued s Chi-squre(df=k) under he null of insrumen vlidiy. (6) Wld es is he es sisics for he esimed coefficien is zero, disribued s Chi-squre(df) under he null of he esimed coefficien is zero. The criicl vlues of Chi-squre (df=) re 4.61, 5.99, nd 9.1 he 1%, 5% nd 1% significn levels, respecively. (7) Time effecs nd indusry effecs re conrolled in he esimions. (8) See noes o Tble 1 for definiion nd mesuremen of vribles; df = degrees of freedom; p = p-vlue. 4 SOAS Universiy of London

26 Discussion Pper 95 Appendix: An invesmen model wih credi rings We model how mngers my mnipule invesmen decisions o influence he ssessmen of he firm s credi quliy by poenil exernl lenders nd credi rings gencies nd how he ex-pos percepion of he firm s quliy in urn ffecs he firm s invesmen behviour. We ssume h mngers nd incumben shreholders hve he sme ineress in responding o credi rings. Mngers driven by heir creer concerns do no like oo high credi rings due o he possibiliy of credi rings downgrde. Incumben shreholders do no like oo high credi rings eiher, due o wo min resons. Firs, he sock price recs negively o credi rings downgrde (Griffin nd Snvicene, 198; Holhusen nd Lefwich, 1986; Cornell e l., 1989). When credi rings re oo high o susin, he likelihood of credi rings downgrde is higher. Second, he firm my borrow more wih higher credi rings, which my increse he risk of bnkrupcy nd induce sses subsiuion beween debholders nd shreholders (Myers, 1977). Hence, in deriving he model, we re mngers nd incumben shreholders s being on he side of he firm, while poenil exernl lenders nd credi rings gencies re on he oher side of he gme. Conflics of ineres exis beween he wo plyers on ech side. Poenil exernl lenders re no ble o disinguish beween good nd bd firms due o symmeric informion problems, so hey rely on recommendion from hird-pry, such s credi rings score provided by recognised credi rings gency, o upde heir beliefs bou he quliy of he firm. All pries involved hve he sme prior beliefs bou he quliy of he firm bsed on public vilble informion. The invesmen decision mde by mngemen (on behlf of incumben shreholders) is no observble for poenil exernl lenders nd credi rings gencies. Bu hey cn observe he oucome of he invesmen decision bsed on some indicors of opering performnce, for exmple, he level of oupu. They upde heir beliefs bou he firm s quliy following Byesin upding process. However, invesmen oucomes cnno be observed wih 1% precision. There re wo ypes of unceriny. Firs, he quliy of he firm is no compleely known by poenil exernl lenders nd credi rings gencies, which mens h here is some Cenre for Finncil nd Mngemen Sudies 5

27 Credi Rings nd Corpore Invesmen: UK Evidence unceriny wih respec o he quliy of he firm. Second, here re some exernl sochsic forces ouside he firm h re relevn, e.g. he mcroeconomic siuion, compeiion, nd he cpil mrke, ec. These exernl uncerinies blur he observion of invesmen oucomes nd hence provide mngers wih chnces o influence he ex-pos ssessmen on he firm s quliy by poenil exernl lenders nd credi rings gencies. We formlize he invesmen decision using he following invesmen model: T MxE ρ π (A1) = I s.. = p Y w L p I p G( I, K ) π (A) ( ) K 1 = I + 1 K δ (A3) where E is he expecions operor; ρ is he discoun fcor; π is ne opering profis for period ; Y, K, L, nd I re oupu, beginning-of-period cpil sock, lbour inpu, nd gross invesmen of he firm ime, respecively; w, p, nd p I re he nominl wge re, he oupu price nd he price of cpil goods for he period ;. G ( I, K ) is he inernl convex cos funcion of djusing he cpil sock; nd δ is he consn depreciion re of cpil. Following Nrynn (1985) nd Holmsröm (1999) we ssume h he observble oupu is liner funcion of invesmen, he firm s quliy, nd rndom fcor: = +η + ε (A4) Y I Where Y is he oupu observed by poenil exernl lenders nd credi rings gencies he end of period ; I is he invesmen decision vrible; η denoes he firm s quliy; nd ε s re rndom erms, which re independenly nd normlly disribued wih men zero nd vrince Expression (A4) ses h he observble invesmen oucome (i.e. oupu) is deermined by he cion ken by mngemen (i.e. invesmen), he quliy of mngemen (he firm), nd some rndom fcors. The quliy of he firm η is unknown bu poenil exernl lenders nd credi rings gencies hold prior belief bou η. The prior disribuion of η is ssumed o be norml ε. 6 SOAS Universiy of London

28 Discussion Pper 95 wih men m nd vrince. A ime poenil exernl lenders nd credi rings gencies upde heir beliefs bou η bsed on observions of he invesmen oucomes in he ps, i.e. he hisory of oupu ( Y ) 1,, Y 1 condiions of invesmen: Y L. Therefore, using (A4) in (A), we obin he following firs order T ρ E[ η Y ] G + =, = I I ( I K ) λ (A5) Where λ is he Lgrnge muliplier (he shdow price of cpil). I is o be noed h he invesmen decision policy equion (A5) shows n imporn difference from he sndrd invesmen model; h is, n ddiionl erm T ρ E η = I [ Y ] ppers in he firs order condiions of invesmen nd his is he mrginl reurns of invesmen o he firm s quliy. We need o solve T ρ E η = I [ Y ] : he mrginl reurn of invesmen o he firm s quliy, which depends on he ex-pos ssessmen on he firm s quliy ρ E [ Y ] T = η. Adping he ides from Nrynn (1985) nd Holmsröm (1999), we ssume h lhough poenil exernl lenders nd credi rings gencies re no ble o observe he invesmen decision mde by he firm, hey re ble o infer he equilibrium decision, herefore in equilibrium observing oupu Y will be equivlen o observing he sequence: 1 where ( ) Y 1 ( Y ) η + ε = Y I (A6) 1 I snds for he equilibrium decision rule, ( Y Y, Y ) = 1, 1 Y K is he hisory of oupu. Since he prior disribuion of η is known wih men m nd vrince disribuion of η ime is norml wih men m, nd vrince (see DeGroo, 197):, he poserior Cenre for Finncil nd Mngemen Sudies 7

29 8 ( ) ( ) 1 ε ε Y I Y m m T + + = = (A7) ε ε + = (A8) Tking expecions of (A6), he erm [ ] Y E η cn be compued by using (A7). I cn be shown h he mrginl reurns of invesmen o he firm s quliy ime is (lso see Nrynn, 1985; nd Holmsröm, 1999): [ ] η ε I Y E + = (A9) Using he sndrd djusmen cos funcion (see Whied, 199), ( ) K c K I K I G, =, hen: [ ] c K I I K G I =, (A1) Using (A9) nd (A1) in (A5), he opiml invesmen equion becomes: ( ) 1 1 λ ε c K I = (A11) The invesmen equion (A11) inroduces exernl unceriny ( ) ε nd he percepion of he firm s quliy ( ) ino he sndrd invesmen model. We see h he firm s invesmen re is funcion of no only he shdow price of cpil ( λ ), rdiionl deerminn of fixed invesmen, bu lso exernl unceriny nd he percepion of he firm s quliy. A huge moun of evidence shows h exernl unceriny discourges invesmen (Lensink, Bo nd Serken, 1). Our model confirms his sylized fc on he invesmenunceriny relionship. From he invesmen model (A11) i is eviden h ( ) ( ) 1 < + = ε ε K I, i.e. exernl unceriny hs negive effec on invesmen. Credi Rings nd Corpore Invesmen: UK Evidence SOAS Universiy of London

30 Discussion Pper 95 Besides exernl unceriny, our model shows h he percepion of he firm s quliy I K 4 1 ε ε + imporn for invesmen. As we cn see from equion (A11), ( ) = > sugges h when he firm s quliy is no well-known o he public ( lrger inves more, while when he firm s quliy is well-known o he public ( smller is lso, which ), hen he firm will ), hen he firm invesmen less. If we use he level of nd he chnges in he firm s credi rings score o proxy for he percepion of he firm s quliy ( ), hen our model predics h firms h hve higher credi rings ( smller ) will hve lower invesmen. This is becuse if he firm is well-known o poenil exernl lenders nd credi rings gencies, hen he mngers who re highly exposed o he public will hve much less discreion in mking corpore decisions. When exernl unceriny is high, he mngers re more uncerin bou he invesmen oucomes. No mer how hrd he mngers ry, only smll proporion of he vriion of he oucome is ribued o he firm s quliy (o he mngers), while he vriion of he oucome of he invesmen decision will be lrgely ribued o unceriny surrounding exernl fcors. This reduces he incenives for he mngers o inves. When condiions re unfvorble, by following sfer invesmen policy, he mngers cn les void dmging heir repuion. Hence in priculr when exernl unceriny is high, he firm h hs high credi rings, i.e. well-known o he public ( smller will be unwilling o underke ddiionl risky invesmen. In sum, our heoreicl model shows h firm s credi ring, s proxy for he firm s credi quliy, my ffec he firm s invesmen decision vi corpore governnce chnnels. In he model we emphsize h mngeril creer concerns my be n effecive mechnism in shping he relionship beween credi rings nd invesmen. ), Cenre for Finncil nd Mngemen Sudies 9